UGA ECON 4020 Chatterjee CH 5: Inflation
quantity theory of money three building blocks
1. The factors of production and the production function determine the level of output Y. We borrow this conclusion from Chapter 3. 2. The money supply M set by the central bank determines the nominal value of output PY. This conclusion follows from the quantity equation and the assumption that the velocity of money is fixed. 3. The price level P is then the ratio of the nominal value of output PY to the level of output Y
Fisher Effect
According to the quantity theory, an increase in the rate of money growth of 1 percent causes a 1 percent increase in the rate of inflation. According to the Fisher equation, a 1 percent increase in the rate of inflation in turn causes a 1 percent increase in the nominal interest rate. The one-for-one relation between the inflation rate and the nominal interest rate is called the Fisher effect
shoeleather cost of inflation
Costs of expected inflation caused by people having to make more trips to the bank to make withdrawals because they do not want to keep cash on hand.
general money demand function
(M/P)^d = L(i,Y) where L is money demand. This equation states that the demand for the liquidity of real money balances is a function of income and the nominal interest rate. The higher the level of income Y, the greater the demand for real money balances. The higher the nominal interest rate i, the lower the demand for real money balances.
List all the costs of inflation you can think of, and rank them according to how important you think they are.
Menu cost, shoeleather cost, tax distortion, unexpected inflation costs, relative price variability
quantity equation
Money x Velocity = Price x Transactions M x V = P x T can also replace T with Y
nominal interest rate
the interest rate actually paid for a loan that the bank pays
if the nominal interest rate and the level of output are held constant:
the price level moves proportionately with the money supply.
the quantity theory of money states that the central bank, which controls the money supply, has ultimate control over the rate of inflation. If the central bank keeps the money supply stable:
the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.
ex ante real interest rate
the real interest rate that the borrower and lender expect when the loan is made i - Eπ Eπ is expected future inflation
How do Most hyperinflations begin
when the government has inadequate tax revenue to pay for its spending, and turns to printing money
quantity theory of money
a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate
money demand function
an equation that shows the determinants of the quantity of real money balances people wish to hold. (M/P)^d = kY Where k is a constant that tells us how much money people want to hold for every dollar of income
Fisher Equation shows that nominal interest rate can change for two reasons
because the real interest rate changes or because the inflation rate changes
why do economists believe a small increase of 2-3% is a good thing?
cuts in nominal wages are rare: firms are reluctant to cut their workers' nominal wages, and workers are reluctant to accept such cuts A 2 percent wage cut in a zero- inflation world is, in real terms, the same as a 3 percent raise with 5 percent inflation, but workers do not always see it that way. The 2 percent wage cut may seem like an insult, whereas the 3 percent raise is, after all, still a raise. May make labor markets work better.
if velocity is fixed, the quantity of money:
determines the dollar value of the economy's output
hyperinflation
episodes of extraordinarily high inflation
Fisher effect equation
i = r + Eπ
Fisher equation
i = r + π show that the nominal interest rate is the sum of the real interest rate and the inflation rate
real interest rate
increase in your purchasing power r = i - pi Where i is nominal interest rate and pi is
transactions velocity of money (V)
measures the rate at which money circulates in the economy. In other words, velocity tells us the number of times a dollar bill changes hands in a given period of time.
inflation
over production of money, decreases money value
A government can finance its spending in three ways
raise revenue through taxes borrow from the public by selling government bonds Print Money
seigniorage
revenue raised by the printing of money
Cagan model
shows how the price level is related to current and expected future monetary policy. In particular, the analysis concludes that the price level depends on a weighted average of the current money supply and the money supply expected to prevail in the future
menu costs
the costs to firms of changing prices the higher the rate of inflation, the more often restaurants have to print new menus
Explain the roles of monetary and fiscal policy in causing and ending hyperinflations.
Hyperinflation typically begins when the government finances large budget deficits by printing money. They end when fiscal reforms eliminate the need for seigniorage. Caused by printing too much money to end budget deficits.Ended by increasing taxes and lowering spending.The government must also have credibility.
real money balances
M/P Real money balances measure the purchasing power of the stock of money. For example, consider an economy that produces only bread. If the quantity of money is $10, and the price of a loaf is $0.50, then real money balances are 20 loaves of bread. That is, at current prices, the stock of money in the economy is able to buy 20 loaves
What does the assumption of constant velocity imply?
MV = PY with V constant implies that a change in the quantity of money M must cause a proportionate change in nominal income PY. That is, if velocity is fixed, then the quantity of money determines the nominal value of the economy's output/GDP.
Write the quantity equation and explain it.
MV=PY The terms on the right-hand side represent the price level (P) and Real GDP (Y). Taken together these two terms represent Nominal GDP or a measure of the total spending that takes place in an economy in a given time period. On the left-hand side, M represents some measure of the money supply, perhaps M1, and 'V' represents the velocity of this monetary measure. Velocity represents the number of times money changes hands in support of the total spending in an aggregate economy.
Suppose that every month the price level rose by 1/2 percent. What would be the social costs of such a steady and predictable 6 percent annual inflation?
One cost is the distorting effect of the inflation tax on the amount of money people hold A second cost of inflation arises because high inflation induces firms to change their posted prices more often A third cost of inflation arises because firms facing menu costs change prices infrequently; therefore, the higher the rate of inflation, the greater the variability in relative prices A fourth cost of inflation results from the tax laws. Many provisions of the tax code do not take into account the effects of inflation. Inflation can alter individuals' tax liability, often in ways that lawmakers did not intend A fifth cost of inflation is the inconvenience of living in a world with a changing price level
Define the terms real variable and nominal variable, and give an example of each.
Real variables are measured in physical units, and nominal variables are measured in terms of money. Real variables have been adjusted for inflation and are often measured in terms of constant dollars, while nominal variables are measured in terms of current dollars. For example, real GDP is measured in terms of constant base-year dollars, while nominal GDP is measured in current dollars. An increase in real GDP means we have produced a larger total quantity of goods and services, valued in base-year dollars. As another example, the real interest rate measures the increase in your purchasing power, the quantity of goods and services you can buy with your dollars, while the nominal interest rate measures the increase in the amount of current dollars you possess. The interest rate you are quoted by your bank, for example 8 percent, is a nominal rate. If the inflation rate is 3 percent, then the real interest rate is 5 percent, meaning your purchasing power has only increased by 5 percent and not 8 percent. The quantity of dollars you possess has increased by 8 percent but you can only afford to buy 5 percent more goods and services with these dollars.
If inflation rises from 6 to 8 percent, what happens to real and nominal interest rates according to the Fisher effect?
The Fisher equation expresses the relationship between nominal and real interest rates. It says that the nominal interest rate i equals the real interest rate r plus the inflation rate π: i = r + π. This tells us that the nominal interest rate can change either because the real interest rate changes or the inflation rate changes. The real interest rate is assumed to be unaffected by inflation; as discussed in Chapter 3, it adjusts to equilibrate saving and investment. There is thus a one-to-one relationship between the inflation rate and the nominal interest rate: if inflation increases by 1 percent, then the nominal interest rate also increases by 1 percent. This one-to-one relationship is called the Fisher effect.If inflation increases from 6 to 8 percent, then the Fisher effect implies that the nominal interest rate increases by 2 percentage points, while the real interest rate remains constant.
Who pays the inflation tax?
The answer is the holders of money. As prices rise, the real value of the money in your wallet falls. Therefore, when the government prints new money for its use, it makes the old money in the hands of the public less valuable. Inflation is like a tax on holding money.
income velocity of money (V)
The income velocity of money tells us the number of times a dollar bill enters someone's income in a given period of time.
ex post real interest rate
The real interest rate that is actually realized i - π