macro analysis ch 5

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.

says that the nominal interest rate moves one-to-one with expected inflation

The Fisher Effect

the cost of changing a price

menu cost

the real interest rate is the ______ __________rate corrected for the effects of inflation

nominal interest

the opportunity cost of holding money

nominal interest rate

hyperinflations typically begin when governments finance large budget deficits by

printing money

implies that the price level is proportionate to the quantity of money

quantity theory

the revenue that the government raises by printing money

seigniorage

hyperinflations end when fiscal reforms eliminate the need for

seingiorage

during hyperinflations, most of the costs of inflation become

severe

the cost of inflation from reducing real money balances, such as the inconvenience of needing to make more frequent trips to the bank.

shoeleather cost

the quantity theory of money assumes that the velocity of money is ___________ and concludes that nominal GDP is proportional to the ____________________

stable, stock of money

An economic scenario that occurs when there is an intervention in a given market by a governing body.

tax distortion

T/f the costs of expected inflation include shoeleather costs, menu costs, the cost of relative price variability, tax distortions, and the inconvenience of making inflation corrections

true

t/f according to classical economic theory, money is neutral: the money supply does not affect real variables.

true

t/f although seigniorage is quantitatively small in most economies, it is often a major source of government revenue in economies experiencing hyperinflation

true

t/f inflation improves the functioning of labor markets by allowing real wages to reach equilibrium levels without cuts in nominal wages

true

list all of the costs of inflation you can think of, and rank them according to how important you think they are

Hyperinflation is always a reflection of monetary policy. That is, the price level cannot grow rapidly unless the supply of money also grows rapidly, and hyperinflations do not end unless the government drastically reduces money growth. This explanation, however, begs a central question: why does the government start and then stop printing large quantities of lots of money? The answer almost always lies in fiscal policy: when the government has a large budget deficit (for example due to a recent war or some other major event) that it cannot fund by borrowing, it resorts to printing money to pay its bills. Only when the fiscal problem is alleviated,—by reducing government spending and / or collecting more taxes,—can the government hope to slow its rate of money growth.

what does the assumption of constant velocity imply?

If we assume that velocity in the quantity equation is constant, then we can view the quantity equation as a theory to study the effect of changes in the money supple (M). The quantity equation with fixed velocity states that: MV = PY. If velocity V is constant, then a change in the quantity of money (M) causes a proportionate change in nominal GDP (PY). If we assume further that output is fixed by the factors of production and the production technology such that Y is constant in the equation, then we can conclude that the quantity of money determines the price level. This is called the quantity theory of money.

if inflation rises from 6-8 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 holders of money pay the inflation tax. As prices rise, the real value of the money that people hold falls—that is, a given amount of money buys fewer goods and services since prices are higher. This loss of real purchasing power is akin to a 'tax' on the money held.

write the quantity equation and explain it

The quantity equation is an identity that expresses the link between the number of transactions that people make and how much money they hold. We write it as Money x Velocity = Price x Transactions M x V = P x T. The right side of the quantity equation tells us about the value of transactions in monetary terms that occur during a given period of time, for example, a year. T represents the total number of transactions. P represents the price of a typical transaction. Hence, the product P x T represents the amount of dollars exchanged in a year. The left side of the quantity equation tells us about the money used to make these transactions. M represents the quantity of money in the economy. V represents the transactions velocity of money—the rate at which money circulates in the economy. Because the number of transactions is difficult to measure, economists usually use a slightly different version of the quantity equation, in which the total output of the economy Y replaces the number of transactions T: Money x Velocity = Price Output M x V = P x Y. P now represents the price of one unit of output, so that P x Y is the dollar value of output—nominal GDP. V represents the income velocity of money—the number of times a dollar bill becomes a part of someone's income.

T/F the rate of growth in the quantity of money determines the inflation rate

True

if one expects the demand for money to depend on the nominal interest rate, then the price level depends both on the current quantity of money and the quantities of money expected in the future T/F

True

The ex post real interest is based on ___________ inflation, whereas the ex ante real interest rate is based on ___________ inflation

actual; expected

the theoretical separation of real and nominal variables is called the

classical dichotomy

allows us to study how real variables are determined without any reference to the money supply

classical theory

is the price of a commodity such as a good or service in terms of another; i.e., the ratio of two prices.

cost of relative price

unexpected inflation cause arbitrary redistribution of wealth between creditors and ______________

debtors

the real interest rate that the borrower and lender expect when the loan is made

ex ante real interest rate

the real interest rate that is actually realized

ex post real interest rate