Test #2

arbitrary wealthy distribution

- someone gains at another expense- can be due to inflation being different from expected inflation

costs of unanticipated inflation

- when anticipation takes you by surprise the costs get much larger! - If everyone expects inflation to be 5% per year, but it actually turns out to be 8%, unexpected inflation is 3%. • If you save $1000 in the bank with a stated 7% interest rate, what is the effect on you? • You expected a 2% real interest rate, but only get -1%. Your bank gains. 2-3 (unexpected inflation)= -1

looking at money demand equation more realistically

-(M/P)d = kY (The equation says more income leads to more purchases leads to more demand for money) We can re-write this as a general functional form: • (M/P )d = L(Y). • "L" stands for "liquidity." Money demand is also called "liquidity demand." • If the money market is in equilibrium, supply (M/P) equals demand (M/P )d • So, M/P = L(Y).

3) relative price distortions

-Different firms change their prices at different times, leading to relative price distortions... ...causing microeconomic inefficiencies in the allocation of resources. -Example: Suppose a firm issues new catalog every January. As the all other prices rise throughout the year, the firm's relative price will fall.

common misconception about inflation: Everything is more expensive, which reduces my standard of living

-If nominal income keeps up with inflation, most people's standard of living is not reduced. • There is a difference between the price level and the relative price of a good. • The latter makes a good more expensive.

How P responds to Δπ e

-So, even before M changes, P will increase simply because people expect M to increase. • This is called a self-fulfilling prophecy. • Inflation can be self-fulfilling - this is one reason why inflation can be difficult to control.

investing domestically or abroad?

-The decision of investing domestically or abroad is influenced by the real interest rate. -The higher the domestic real interest rate, the more willing foreigners are to lend to the U.S. -Denote net capital outflow as CF- movement of assets out of country or exports Higher r → lower CF- the higher the r the less assets their are to move because home will want to invest into the high real interest rates CF = CF( r ).

Increased uncertainty

-This forces people to utilize resources to avoid potential losses - a waste of resources and cost to society. • With high uncertainty, investors might stop making long- run investment plans - another net loss to the economy.

Benefit of inflation

-even when equilibrium real wage falls nominal wages are rarely reduced -Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. -Therefore, moderate inflation improves the functioning of labor markets.

Jane considers how much cash she should hold for this month. She usually holds $400 of cash. There is a 3% inflation rate. Jane holds her other wealth in a mutual fund, which pays a 5% real return per year. What's her return on cash, the real cost of holding cash, and if her mutual fund pays 7% now should she hold more or less cash?

-her return on cash is -3% a year (cash loses value). as cost of holding money is negative of expected inflation (-Eπ) -So the real cost of holding cash is 8%. (i=Eπ +r....8= 3+5) -If her mutual fund now pays a 7% real return, Jane will probably hold even less cash.

arbitrary redistribution of purchasing power (unexpected inflation)

-if inflations more than expected inflation than real interest rate is less than expected interest rate -if inflation is less than expected inflation purchasing power is transferred from borrowers to lenders (lenders making less profit)

costs of anticipated inflation

-inflation still corrodes the value of cash- people will try to hold less of it -cost of holding cash is the nominal interest rate, so when inflation goes up so does nominal interest rate and real money demand goes down -people use ATM's more and companies use accountants more

5) general inconvenience

-makes it hard to compare nominal values from different time periods, this complicates long-range financial planning Examples: •Parents trying to decide how much to save for the future college expenses of their (now) young child. •Thirty-somethings trying to decide how much to save for retirement

(M/P )^d real money demand depends

-negatively on i, i is the opportunity cost of holding more -positively on Y, higher Y means more spending and thus you need more money -(M/P )^d = L(i, Y)

Suppose the growth rate of Y falls to 1% per year. (M= 5%) ‣ What is the change in π ? ‣ What must the Fed do if it wishes to keep π constant?

-original: π=M-Y= 5-2= 3% - new: π=M-Y= 5-1= 4%, inflation increased by 1% -To prevent inflation from rising, Fed must reduce the money growth rate by 1 percentage point per year.

relative price

-serves as a signal in the economy, ratio of 2 prices ex) farmers have to know the price of wheat relative to the price of corn to make production decisions -With inflation, firms need to raise their prices at similar paces to keep relative prices unchanged. • Because of menu costs, few firms can change prices continuously. • Some change prices more often than others.

π (created by quantity theory of money equation)

-the change in velocity is constant so you can take it out of equation leaving: ΔM/M=ΔP/P+ΔY/Y -π (Greek letter "pi") denotes the inflation rate: π =ΔP/P Solve for π to get: π =ΔM/M − ΔY/Y - normal economic growth requires an increase in money supply which can lead to inflation via the equation

Classical dichotomy

-the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables.

why would a government create hyperinflation?

-when a government can't raise taxes or sell bonds, it has to finance spending increase by printing money, you can say stop printing money- but this is not a plausible solution in the real world you need drastic and painful fiscal policy ex) War reparations reduced government revenue. So it printed money to finance purchases, In 1923, the inflation rate was 3,250,000% per month, Prices roughly doubled every two days, ended severe fiscal cuts, children began to use money as a toy bc it had no value

hyperinflation

-when inflation is greater than or equal to 50% per month due to an excessive money supply growth, if the gov prints money rapidly enough -all the costs of moderate inflation are huge under hyperinflation! -money ceases to be a store of value and can fail under other functions as well (unit of account, median of exchange) -People may conduct transactions with barter or a stable foreign currency.

net capital inflow or negative net capital outflow

A country that is getting an import or receiving from other countries, they can pay for what they're importing with gold or sell a bond to the country they're trading with, with a promise to pay them back in the future

depreciation

A fall in the exchange rate is called a depreciation. An appreciation of the dollar is a depreciation of the yen.

what determines money demand (how much money people have to spend)

A simple money demand function: (M/P)d = kY where k = how much money people wish to hold for each dollar of income. (k is exogenous- related to external factors)

closed economy

An economy that does not interact with the rest of the world (no countries are closed economies)

open economy

An economy that interacts freely with other economies around the world. An open economy has movement of capital into and out of a country/market.

what controls Real GDP

But real GDP is determined by the economy's supplies of K and L in production function

Neutrality of money:

Changes in the money supply do not affect real variables. -In the real world, money is approximately neutral in the long run, in countries where the inflation rate is mild.

velocity changing in Real life example- doesn't happen often so we assume it's constant

Example: when ATM was introduced, people started to hold less cash and make more frequent use the ATMs. V increases. • However, velocity does not change often. The constant velocity assumption will help us derive the theory.

who controls nominal GDP

Fed can control Money Supply (M), so fed controls nominal GDP (PxY)

How P responds to ΔM

For given values of r, Y, and πe a change in M causes P to change by the same percentage - quantity theory of money.

open economy

In an open economy, a country's citizens can invest in other countries, and foreign citizens can invest in the domestic economy. CF needs to be added to the model.

quantity equation

M ×V = P ×Y follows from the preceding definition of velocity. • It is an identity: it holds by definition of the variables.

(M/P ) = L(r + πe, Y)

M/P is the supply of real money balances L(r + πe, Y) is real money demand

Nominal variables:

Measured in money units, e.g., - nominal wage: Dollars per hour of work. - nominal interest rate: Dollars earned in future by lending one dollar today. - the price level: The amount of dollars needed to buy a representative basket of goods.

Real variables:

Measured in physical units - quantities and relative prices, for example: - quantity of output produced - real wage: output earned per hour of work - real interest rate: output earned in the future by lending one unit of output today

Money and inflation: summary

Money affects inflation in 2 ways -more money supply leads to a higher price and more inflation (quantity theory) -more future money supply leads to a higher expectation for future inflation, leading to higher nominal interest rates, causing less money demand, then causing higher velocity then higher inflation -Inflation is driven by both current growth in the money supply and its expected future growth. -only credible central banks can really control inflation, banks credibility can affect expectation and if it has a reputation of not being able to control inflation any scare can lead to true inflation

NX (net exports)= X(exports)-IM(imports)= Y-(C+I+G)

NX = Y - (C+I+G) (Y=C+I+G+Nx) = Y-C-I-G = Y-(C+G)-I Recall that national Saving is Y-(C+G) So, NX = S - I Define S - I as net capital outflow

net capital outflow

Net capital outflow = S - I (country's savers supply more funds than its firms wish to borrow for investment) = net outflow of "loanable funds" = net purchases of foreign assets When S > I, country is a net lender When S < I, country is a net borrower (inflow of loanable funds bc firm is borrowing from another country)

inflation tax:

Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money.

1) shoe leather cost (cost of expected inflation)

Shoe leather cost refers to the cost of time and effort that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank -small cost if inflations modest

what determines the exchange rate?

The accounting identity says NX = S - I = CF We saw earlier how S - I is determined: S depends on domestic factors (output, fiscal policy variables, etc.) CF is determined by the interest rate r So, ε must adjust to ensure NX(ε) = CF

Implications of the quantity theory

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. 1. countries with higher money growth rates should have higher inflation rates. 2. the long-run trend behavior of a country's inflation should be similar to the long-run trend in the country's money growth rate.

net export function

The net exports function reflects this inverse relationship between NX and ε : NX = NX(ε )

Common misperception about inflation: inflation reduces real wages

This is true only in the short run, when nominal wages are fixed by contracts. • In the long run, inflation is often anticipated, and the nominal wage increases with inflation.

seigniorage

To spend more without raising taxes or selling bonds, the government can print money. Most governments do not really "print" money to purchase things. • Government issues bonds~>central bank buys the bonds~>credits the government's account with more money~>government spends the money (in the US the fed can't technically buy bonds directly from gov so they get it from the financial market better known as the "open market" -Government issues bonds to financial market ~>Fed buys bonds from market~>government collects seigniorage indirectly.

trade deficit

US started running trade deficit in the 1970's, exports less than imports, you spend more than you produce and imports are greater than exports, economy in recession in 80's and 2008 trade deficit shrinks bc income goes down so we can afford to buy less from rest of world for that period of time, net capital inflow

use nominal GDP as a proxy for total transactions

V= PxY/M

equation of velocity

V=T/M V = velocity T = value of all transactions M = money supply

How policies influence the real exchange rate

What happens if the government reduces national saving by increasing spending or cutting taxes? Lower saving reduces the supply of dollars to be invested abroad. This causes the real exchange rate to rise.

Increased uncertainty due to cost of high inflation

When inflation is high, it's more variable and unpredictable: π turns out different from π e more often, and the differences tend to be larger (though not systematically positive or negative) • Arbitrary redistributions of wealth become more likely. • This creates higher uncertainty, making risk averse people worse off.

example of capital outflow

You bought a British sweater for $75 — an import from Britain. The British exporter now holds $75, a cash asset of the U.S. The British exporter can also use the $75 to buy a U.S. stock or bond. Either way, Britain's capital outflow increases, and U.S. capital outflow decreases. What if the British exporter goes to his bank and exchanges the $75 to British pounds? It does not change the situation. The bank now owns the U.S. asset. U.S. capital outflow still decreases.

classical view of inflation

a change in the price level is just a change in the units of measure (since everything goes up with inflation)

seigniorage in the US

a small fraction of government revenue. • Private investors are usually willing to buy U.S. Treasury bonds. • There is no need for the Fed to "monetize" the debt. • In some countries, seigniorage can be a major source of revenue.

π

actual inflation rate (not known until after it has occurred)

so why then is inflation a problem, what are the social costs?

anticipated inflation- everyone knows inflation will be a certain rate unanticipated inflation- inflation that takes people by surprise

In the quantity theory of money we assume V is

constant and exogenous making the V have a bar over it

nominal exchange rate

e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency. Example: the current exchange rate between the dollar and the euro is 0.89 euros/$. Example: the exchange rate between the Chinese Yuan and the dollar is 6.96 Yuan/$.

Money market:

economists like to think that there is a market for money (cash and checking account balances). Suppliers the central bank and the demands are businesses, governments, and individuals

employees vs. employers (unexpected inflation)

employees vs. employers - If inflation is higher than expected, the real wage is less than expected - the employers gain at the expense of the employees. • More generally, many long-term contracts not indexed, but based on π e.

i - π ^e

ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan

i - π

ex post real interest rate: the real interest rate actually realized

π ^e

expected inflation rate

ΔY/Y depends on

growth in the factors of production and on technological progress (all of which we take as given, for now) -Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.

countries overall trade balance is

highly related to a countries saving and investment decisions...Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ). The fewer the exports the more capital inflow or they borrow more. If you are exporting a lot you are bringing in capital so you don't have to borrow as much bc money coming in from your exports (but you have money to lend making you a lender). If you are importing a lot you are buying a lot so you have to borrow more to buy all those things (you are a borrower)

The Fisher equation:

i = r + π S = I determines r. • Hence, an increase in π causes an equal increase in i !!!!!!!!!!!!!! • This one-for-one relationship is called the Fisher effect.

Nominal interest rate,

i, not adjusted for inflation

Above 45 degree line:

inflation exceeds average money growth. At a given level of money growth, the higher the level of real GDP growth (Y), the lower the level of inflation.

international capital flows

international borrowing and lending, financial flow or "loanable funds"

in a closed economy

investment is a function of real interest rate Production function: Y= F(K,L) Consumption function: C= C(Y-T) Investment function: I=I(r)~> real interest rate exogenous policy variables: G=constant G, T=constant T

The real exchange rate and the economy

its just a relative price if it, if it rises US goods become more expensive relative to foreign goods- exports fall and imports rise

capital outflow

lending to other countries

If too much money causes inflation, why do governments still supply too much of it?

main reason is printing money can be a source of revenue. -Government's "normal" revenue sources: - Taxes - Debts

last component of money demand equation is...

nominal interest rate (i), -the opportunity cost of holding money (instead of bonds or other interest-earning assets). - Hold money: return is negative expected inflation , hold interest-bearing assets: return is real interest rate. Total opportunity cost is nominal interest rate= expected inflation+ real interest rate (i=Eπ +r) • Hence, ↑i ⇒ ↓ in money demand.

Real wages

nominal wage minus inflation. In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate.

lenders

people in country have more money than companies need to borrow, if theirs more money in the bank than companies need to borrow from people morey can be lent to other countries, S>I

borrowers

people in the money have less money than companies need so they need to look at foreign countries to borrow money, I>S

trade policies

policies designed to directly alter the amount of goods and services exported and imported. Examples- tariffs are taxes on imports quotas are a quantity restriction on imports

economy grew but the supply of gold was relatively constant. What does the theory predict?

price decreases

new gold was discovered in Alaska, Australia, and South Africa. What does the theory predict?

price increases

P

price of output or inflation (GDP deflator)

Y

quantity of output (Real GDP)

Real interest rate,

r, adjusted for inflation: r = i − π

Consider an example. Dave lends $100 to John for one year. They agree on a 5% interest rate for the loan. • Suppose the inflation rate is also 5%., find real and nominal interest rate.

real Interest rate= 5 (i)-5(i)= 0 nominal interest rate= 5

M/P (purchasing power of money supply)

real money balances, the purchasing power of the money supply. Example: if M=$100, price of bread = $2 per loaf, then real money (real purchasing power of money) = 100/2 = 50 loaves of bread. • In practice, economists use a price index such as CPI to represent P.

appreciation

rise in the exchange rate Example: an appreciation of the dollar happens if the exchange rate goes from 100 yen/$ to 110 yen/$

4) unfair tax treatment

some taxes not adjusted to account for inflation like the capital gains tax Example: - Jan 1: you buy $10,000 worth of IBM stock - Dec 31: you sell the stock for $11,000, so your nominal capital gain is $1000 (10%). - Suppose π = 10% during the year. Your real capital gain is $0. - But the govt requires you to pay taxes on your $1000 nominal gain!! - You need not pay tax, however, if inflation is 0% and your nominal (and real) return is also 0%.

trade surplus

spends less than it produces, exports are greater than imports, net capital outflow

Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4%. If the Fed increases the money growth rate by 2 percentage points per year, what is Δi ?

the change in i is the same as the change in the money growth rate due to Fisher effect (π and i have a 1-to-1 relationship and M is in the inflation and money growth increase together) -2%

2) menu cost (cost of expected inflation)

the cost of changing prices, originally came from when a restaurant had to get new menus when prices changed charging them more money -The higher is inflation, the more frequently firms mustchange their prices and incur these costs. • Examples: - cost of printing new menus - cost of printing & mailing new catalogs

let money supply (M/P)= money demand ((M/P)d = kY) and we get...

the quantity equation- MxV=PxY The connection between them: k = 1/V • When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low).

Velocity

the rate at which money circulates. the number of times the average dollar bill changes hands in a given time period • example: In 2007, - $500 billion in transactions - money supply = $100 billion - The average dollar is used in five transactions in 2007 -so velocity is 5

real exchange rate

the relative price of domestic goods in terms of foreign goods. It is also called "the terms of trade." ex) Suppose a Big Mac is sold at 200 yen in Japan, and $2.50 in the U.S. Suppose the nominal exchange rate is 120 yen/$ What is the real exchange rate between the two currencies using the "Big Mac standard"? We will convert the U.S. price into yen price first: a Big Mac in the U.S. costs $2.5 x 120 = 300 yen The real exchange rate = 300 yen/200 yen = 1.5 To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy 1.5 Japanese Big Macs.

PxY

value of output (nominal GDP)

Nominal wages

wages received by a worker in the form of money

Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4%. What is nominal interest rate, i ?

π= M-Y= 5-2= 3% nominal interest rate (i)= r + π 4+3= 7%

What about expected inflation?

πe may change when people get new information. • EX: Fed announces it will increase M next year. People will expect next year's P to be higher (since money supply and inflation rise tg), so πe rises. • This affects P now, even though M hasn't changed yet....

real exchange rate

ϵ: real exchange rate e: nominal exchange rate P: domestic price level P*: foreign price level real exchange rate= exP/P* ex) Nominal exchange rate: 0.8 euro/$ U.S. CPI: 150 EU CPI: 120 What is the real exchange rate? Answer:e= .8x150/120=1

High vs. low inflation

• How do people behave if the inflation rate is 1000,000%? (Venezuela, 2018) • The cash that people hold loses value rapidly. • People will try hard to spend the money as quickly as possible. Money demand goes down. • What happens to the velocity of money? • It increases (each dollar is used more times). It is like having more money supply. - plus if velocity increases so will inflation (according to formula) this is another reason why high inflation countries lie above the 45 degree line. • This is also why countries with similar money growth can have very different inflation rates • Lesson: the velocity of money is not always stable

What determines what M/P= L(r + πe, Y)

• M exogenous (the Fed) • r adjusts to make Savings (S) = Investment (I) • Y determined by inputs and production function • P adjusts to make the equation hold

(M/P )^d = L(r + πe, Y)

• When people are deciding whether to hold money or bonds, they don't know what inflation will turn out to be. • Hence, the nominal interest rate relevant for money demand is r + π e= i