Ch. 30: Classical Dichotomy and Monetary Neutrality

Govt's budget constraint; 3 sources of income

(1) They can raise taxes (T) (2) They can borrow money by issuing bonds (B) (3) They can print money (M) The government will then use their income to spend on government programs (G) G = T + B + M

how hyperinflation gets started

1. Government spending increases. 2. Government tries to meet the increase in spending by first trying to raise taxes and issuing bonds. 3. Lenders are going to start lending less to the government. 4. The government who now no longer is able to raise taxes, so they print money. 5. Increasing money supply causes the price level to go up (see Quantity Theory of Money). As inflation rises, lenders will be hurt by the inflation. Thus lenders will now start to lend even less to the government (and we go back to Step #3). The only way to break this vicious cycle is eventually to cut the root cause which was the increase in government spending.

Expected Inflation Costs

1. Shoeleather Costs 2. Menu Costs 3. Variability in Relative Prices 4. Tax Code Failures

Unexpected Inflation Costs

debtors will win and creditors will lose. When lending and borrowing money, what creditors and lenders really care about is the real rate of interest. In times of unexpected inflation creditors will be worse off and debtors better off. In times of unexpected deflation creditors will be better off and debtors will be worse off.

Hyperinflation

inflation that exceeds 50% per month. the most costly of inflationary episodes and is very disastrous to a country, not only economically but also socially and politically. One of the most infamous episode of hyperinflation was in Post World War I Germany in the 1920s. The economic and political crisis that came from that episode of hyperinflation would eventually give rise to the Nazi Party.

classical dichotomy

the long-run changes in real variables have no-effect on nominal variables or real variables and vice versa

ex-post real interest rate

the nominal interest rate - actual level of inflation. r = i - π

Fisher effect

the relationship between inflation and the nominal interest rate. If inflation increases by 1% (due to a 1% increase in the money supply) this will increase the nominal interest rate by 1%. The Fisher effect implies that changes in price level will have no effect on the real interest rate. This should already be clear from the classical dichotomy discussed earlier in the chapter. A change in the price level (a nominal variable) cannot cause a change in the real interest rate (a real variable) in the long run.

nominal vs. real variables

things measured as output things that are measured in $

inflation tax

Economists refer to episodes where the government raises revenue by printing money refers to the fact that when the government prints money it causes inflation and makes the dollars less valuable. The people who hold money are able to purchase less with their money.

quantity theory of money

a theory that relates how the quantity of money affects the economy. illustrate the relationship between money demand, prices and quantity of goods purchased The quantity equation shows the link between the total transactions that occur in an economy (P x Y) and the quantity of money in the economy (M). Money x Velocity = Price x Output M x V = P x Y %∆M + %∆V = %∆P + %∆Y

Menu Costs

as prices rise, firms have to keep updating their prices. For some industries there is a cost involved in changing prices. Additional costs could also involve the cost of having to advertise the new prices to potential customers. Restaurants, for example, would have to print new menus constantly to reflect the higher prices in the overall economy.

Shoeleather Costs

Previously, a high inflation rate will cause an increase in the nominal interest rate. High interest rates in turn would lower the demand for money balances. People would rather hold money in the bank than in their wallets or purses. Since people hold less cash on them they have to make more frequent trips to the bank or ATM to withdraw their money. This inconvenience is called shoeleather costs. These costs literally refer to the wear to your shoes from having to go to the bank constantly. With the advent of debit cards, these costs are almost negligible in today's economy.

Variability in Relative Prices

Suppose a firm finds it very expensive to change its prices constantly and fixes the prices of all of the goods it sells for 1 year. For example, JCPennys publishes a catalog each year and the prices quoted are good for 1 year. It would be expensive for JCPenny to have to publish new catalogs whenever prices change. The problem would occur if there is a sudden drop in prices. Suppose, that the unlikely scenario happens and prices drops in half throughout the economy. JCPennys has fixed its prices and thus are unable to lower its prices with the rest of the economy. All of the sudden the prices of JCPenny's products are much higher relative to the prices of all other goods in the economy. In times of falling prices, JCPennys (and other firms that have fixed prices) will see their relative prices rise and demand for their product fall.

Tax Code Failures

Tax laws are based on nominal income and not real income. Suppose for example you got a raise in your income to compensate for inflation in the economy. For example suppose that inflation rate is 15% and your nice boss gives you a 15% raise. In a sense you're no better off than before. Your income can now buy you exactly the same amount of goods as before. However, the IRS doesn't see it that way. The fact that you got a raise will lead to you having to pay higher taxes even though in real terms (or purchasing power) your wages have remained unchanged.

Velocity of Money (V)

The velocity of money is the average number of times per year that a dollar bill changes hand in a given year. V = (P x Y)/M

monetary neutrality.

changes in the money supply has no effect on real variables but can affect nominal variables

ex-ante real interest rate

nominal interest rate - expected level of inflation r = i - πe