Chapter 17: Inflation

An increase in the quantity of money in an economy must be reflected in one of the other three variables:

1. Price level must rise 2. quantity of output must rise 3. velocity of money must fall

Elements necessary to explain the equilibrium price level and inflation rate:

1. Velocity of money is relatively stable over time 2. When central bank changes quantity of money, it changes the quantity of output 3. Money does not effect output because it is determined by productivity Therefore, when the FED raises the money supply, the result is high inflation

Why is Inflation so closely studied/Why might it seem like such a bad thing?

Because most people earn their incomes by selling their services, such as their labor, inflation in incomes goes hand in hand with inflation in prices. Thus, inflation does not in itself reduce people's real purchasing power. Instead there a several "costs" to inflation

How could you avoid the inflation tax?

By holding onto less money

Why is saving less attractive to an economy experiencing inflation

Due to inflation-induced tax changes Solution: Index the tax system

How the growth in the money supply affects interest rates?

In the long run over which money is neutral, a change in money growth should not affect the real interest rate.

Redistribution of wealth caused by unexpected inflation ...

Inflation/Hyperinflation: Debtor benefits more when paying back Deflation: Creditor benefits more when being paid back

That is, why do the central banks of these countries choose to print so much money that its value is certain to fall rapidly over time?

The answer is that the governments of these countries are using money creation as a way to pay for their spending.

Menu Costs

The cost of changing prices

Quantity Equation

The equation M x V = P x Y , which relates the quantity of money, the velocity of money, and the dollar value of the economy's output of goods and services

Relative Price

The price of one thing compared to another

Why are interest rates important?

They link the economy of the present to the economy of the future

Relative price variability

Thus, because prices change only once in a while, inflation causes relative prices to vary more than they otherwise would. When inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources to their best use.

Real Interest Rate

corrects the nominal interest rate for the effect of inflation to tell you how fast the purchasing power of your savings account will rise over time. =Nominal IR - Inflation Rate

Hyperinflation

hyperinflation is generally defined as inflation that exceeds 50% per month. This means that the price level increases more than a hundredfold over the course of a year.

Nominal Interest Rate

tells you how fast the number of dollars in your account will rise over time. = Real IR + Inflation Rate

Fisher Effect

the one-for-one adjustment of the nominal interest rate to the inflation rate Expected inflation moves with actual inflation in the long run, but that is not necessarily true in the short run.

Money Neutrality

the proposition that changes in the money supply do not affect real variables

Velocity of Money

the rate at which money changes hands V=(P x Y)/M P= price level Y= quantity of output M= quantity of money Relatively stable over time

ShoeLeather Cost

the resources wasted when inflation encourages people to reduce their money holdings magnified during hyperinflation

Inflation Tax

the revenue the government raises by creating money When the government prints money, the price level rises, and the dollars in your wallet are less valuable. Thus, the inflation tax is like a tax on everyone who holds money.

Classical Dichotomy

the theoretical separation of nominal and real variables The classical dichotomy is useful because different forces influence real and nominal variables. According to classical analysis, nominal variables are influenced by developments in the economy's monetary system, whereas money is largely irrelevant for explaining real variables.

Nominal Variables

variables measured in monetary units

Real Variables

variables measured in physical units In the long-run, is not effected by money fluctuations or inflation