Economics Review (Chapter 12) - Money Growth and Inflation

Inflation Fallacy

"Inflation robs people of purchasing power and of hard-earned dollars." In fact, when prices rise, buyers make more, and sellers get more. Inflation does not (in itself) reduce people's real purchasing power. By increasing the money supply, people buy more, thus wasting resources, and causing firms to bear the costs. As a result, when inflation occurs, some people will substitute their money holdings with goods such as gold that hold value.

The Costs of Inflation

1. Misallocation of resources from relative-price variability: Firms don't all raise prices at the same time, so relative prices can vary (resulting in a distortion of the allocation of resources). 2. Confusion and inconvenience: Inflation changes the yardstick we use to measure transactions (complicated long-range planning and the comparison of dollar amounts over time). 3. Tax distortions: Inflation makes nominal income grow faster than real income. Taxes are based on nominal income, and some are not adjusted for inflation (causing people to pay more in taxes even when their real incomes don't increase).

Fluctuations in Money Supply and the Effect on Money Demand (COMPLETE BULLSHIT - GOOD LUCK UNDERSTANDING THIS)

As the value of money rises, the price level falls, and the quantity of money demanded decreases. Conversely, a fall in the value of money increases the quantity of money demanded. Price level adjusts to equate the quantity of money demanded with money supply. As money supply increases, the value of money falls and the price level rises.

Increasing Money Supply Causes Price Level to Rise - Why?

At the initial price level, an increase in money supply causes an excess supply of money. People then get rid of their excess money by spending it on goods and services or by loaning it to others, who spend it. This results in an increased demand for goods and services (rich people spend money on shit). ^^^^Since the supply of goods and services does not increase, prices must rise to fit the increase in demand (too many rich people - limited supply of goods and services to waste their money on).

Menu Costs

Costs of changing prices due to inflation (printing new menus, mailing new catalogs with different prices, etc.). Inflation increases menu costs that firms must bear.

Money Supply

Determined by the Fed, banks, and consumers.

Lessons About the Quantity Theory of Money

If real GDP is constant, ----> Then inflation rate = money growth rate If real GDP is growing, ----> Then inflation rate < money growth rate The bottom line: Economic growth increases the # of total transactions. Some money growth is needed for these extra transactions. Excessive money growth causes inflation.

Hyperinflation

Inflation exceeding 50% per month. A little bit of inflation might be ok if fast economic growth is needed. Too much inflation (known as hyperinflation), however, can be a bad thing.

Summary of the Effects of Inflation

Inflation: -> Raises nominal interest rates (Fisher Effect) but not real interest rates. -> Increases the tax burdens of savers. -> Lowers the after-tax real interest rate.

Nominal Variables

Measured in monetary units (ex: amount in paper money). Nominal GDP, Nominal Interest Rate measured in $, Nominal wage measured in $ per hour.

Real Variables

Measured in physical units (ex: pieces of candy). Real GDP, Real Interest Rate measured in quantity of output, Real Wages measured in output.

Classical Dichotomy

People debate whether or not nominal and real variables are related to each other. In reality: If the central bank doubles the money supply, Then all nominal variables (including prices) will double, but all real variables (including relative prices) will remain unchanged.

Price Level, P

Price level is the price of a basket of goods, measured in money. NOTE - Price level effects money demand: An increase in P reduces the value of money, so more money is required to buy goods and services. 1 / P represents the value of $1, measured in goods.

Inflation

Prices rise when the government prints too much money. Excessive growth in the money supply always causes inflation. A general increase in prices and fall in the purchasing value of money. Inflation drives up prices and drives down the value of money. INFLATION RATE = (CPI next year - CPI this year) / CPI next year * 100

The Fisher Effect

Principle of monetary neutrality: ----> An increase in the rate of money growth raises the rate of inflation, but does not affect any real variable. The real interest rate is determined by saving and investment in the loanable funds market. Real interest rate = Nominal interest rate - Inflation rate AND Nominal interest rate = Real interest rate + Inflation rate

Money Demand

Refers to how much wealth people want to hold in liquid form. Dependent on price level (positive relationship) and negatively related to the value of money

Equation of Exchange (with equation)

Relates increases in the money supply to increases in the overall level of prices. Formula: P x Y = M x V

The Inflation Tax (The Ability For The Government to Make Money This Way is The Main Cause of Hyperinflation!)

Revenue the government raises by creating (printing) money. When the government prints money, the price level rises, and the dollars in your wallet are less valuable. Politicians will use this to their advantage, as they will gain revenue from increasing money supply without having to increase taxes (which is like a tax but not a tax).

Price Level

The cost of living. The average of current prices across the entire spectrum of goods and services produced in the economy.

Quantity Theory of Money

The hypothesis that changes in prices correspond to changes in the monetary supply. The quantity of money determines the value of money. Rapid money supply growth during stable periods causes rapid inflation. Prices rise when the government prints too much money. ***Most economists believe the quantity theory is a good explanation of the long-run behavior of inflation*** ***Many also believe money injection in the economy is ok in periods of financial crisis to cause a boom in spending***

Real Wages

The price of labor relative to the price of output Real Wages = Wages / Price level Example: $15 per hour / $5 per unit of output = 3 units of output per hour

Relative Prices

The price of one good relative to another good Example: What is the relative price of CD's in terms of pizza? $15 CD to $10 pizza -> $15/$10 = 1.5 pizzas per CD

Monetary Neutrality

The proposition that changes in the money supply does not affect REAL variables. However, doubling the money supply causes all NOMINAL prices to double.

Velocity of Money (with equation)

The rate at which money changes hands. Formula: V = (P x Y) / M M = money supply V = velocity P x Y = (price level x real GDP) or nominal GDP Example: If velocity = 3, the average dollar was used in 3 transactions.