Chapter 17: Money Growth and Inflation: Macroeconomic

deflation

A situation in which prices fell. (Farmers, who had accumulated large debts, suffered when declines in crop prices reduced their incomes and thus their ability to pay off their debts. They advocated government policies to reverse the deflation.)

The price level must rise, the quantity of output must rise, or the velocity of money must fall.

The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables:

classical dichotomy

The theoretical separation of nominal and real variables. (A dichotomy is a division into two groups, and classical refers to the earlier economic thinkers.)

classical

The theory is call ______ or known to be _______because it was developed by some of the earliest economic thinkers.

Price level

We can view the _____ _____ as a measure of the value of money. A rise in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services.

Suppy and demand

What determines the value of money? (Just as the supply and demand for bananas determines the price of bananas, the supply and demand for money determines the value of money.)

units of money

When prices are quoted in _____ __ ______, they are therefore nominal variables. (Example: When we say that the price of corn is a bushel or that the price of wheat is a bushel, both prices are nominal variables.) (Dollar prices are nominal, relative prices are real variables.)

Hyperinflation

extraordinarily high rate of inflation. (Example:According to the International Monetary Fund, inflation in Venezuela in 2018 reached million percent per year, equivalent to an increase in prices of about percent per day.)

deflation

falling prices result when some event, such as a monetary contraction, reduces the overall demand for goods and services in the economy. This fall in aggregate demand can lead to falling incomes and rising unemployment. In other words, deflation is often a symptom of deeper economic problems.

purchasing power

inflation does not in itself reduce people's real __________ ______. (When prices rise, buyers of goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell.)

money supply

the Federal Reserve, together with the banking system, determines the supply of money. When the Fed sells bonds in open-market operations, it receives dollars in exchange and contracts the money supply. When the Fed buys government bonds, it pays out dollars and expands the money supply. In addition, if any of these dollars are deposited in banks, which hold some as reserves and loan out the rest, the money multiplier swings into action, and these open-market operations can have an even greater effect on the money supply. (For our purposes in this chapter, we ignore the complications introduced by the banking system and simply take the quantity of money supplied as a policy variable that the Fed controls.)

menu costs

the costs of changing prices (During hyperinflations, for example, firms must change their prices daily or even more often just to keep up with all the other prices in the economy.) (One survey found that the typical U.S. firm changes its prices about once a year.)

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. This equation states that the quantity of money (M) times the velocity of money (V) equals the price of output (P) times the amount of output (Y).

increased

the injection of money ________ the demand for goods and services

fisher effect

the one-for-one adjustment of the nominal interest rate to the inflation rate when the Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate. (Maintained a long-term perspective)

capital gains

the profits made by selling an asset for more than its purchase price.

monetary neutrality

the proposition that changes in the money supply do not affect real variables (Changes in the supply of money, according to classical analysis, affect nominal variables but not real ones. When the central bank doubles the money supply, the price level doubles, the dollar wage doubles, and all other dollar values double. Real variables, such as production, employment, real wages, and real interest rates, are unchanged.)

velocity of money

the rate at which money changes hands the velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

Shoeleather Cost

the resources wasted when inflation encourages people to reduce their money holdings (a cost of inflation)

inflation tax

the revenue the government raises by creating money. (This causes hyperinflation and inflation)

real interest rate

the supply and demand for loanable funds determine the ___ _________ ______.

real wage

unemployment results when the ____ ____ is above the equilibrium level. (Changes in the supply of money, according to classical analysis, affect nominal variables but not real ones. When the central bank doubles the money supply, the price level doubles, the dollar wage doubles, and all other dollar values double. Real variables, such as production, employment, real wages, and real interest rates, are unchanged.)

V=(PxY)/M

v= velocity p=price level y=the quantity of output m=the quantity of money (Suppose that the economy produces 100 pizzas in a year, that a pizza sells for $10, and that the quantity of money in the economy is $50. Then the velocity of money is)

nominal variables

variables measured in monetary units (For example, the income of corn farmers is a nominal variable because it is measured in dollars, whereas the quantity of corn they produce is a real variable because it is measured in bushels.)

real variables

variables measured in physical units. (For example, the income of corn farmers is a nominal variable because it is measured in dollars, whereas the quantity of corn they produce is a real variable because it is measured in bushels.)

prices

Although many variables affect the demand for money, one variable is particularly important: ______ in the economy. People hold money because it is the medium of exchange (Supply and demand)

equilibrium price level.

At the __________ ____ _____, the quantity of money that people want to hold exactly balances the quantity of money supplied by the Fed.

Friedman rule

Milton Friedman pointed out that deflation would lower the nominal interest rate (via the Fisher effect) and that a lower nominal interest rate would reduce the cost of holding money. The shoeleather costs of holding money would, he argued, be minimized by a nominal interest rate close to zero, which in turn would require deflation equal to the real interest rate.

short run

Most economist today believe that over short period of time-within the span of a year or two-monetary changes affect real variables.

accountants

Earlier, we discussed how the tax code incorrectly measures real incomes in the presence of inflation. Similarly, _________ incorrectly measure firms' earnings when prices are rising over time.

higher price level

How much money they choose to hold for this purpose depends on the prices of those goods and services. The higher prices are, the more money the typical transaction requires, and the more money people will choose to hold in their wallets and checking accounts. That is, a _____ _____ ______a lower value of money) increases the quantity of money demanded. (Supply and demand)

P

If _ is the price of goods and services measured in terms of money 1/P is the value of money measured in terms of goods and service (For example, When the price of a cone (P) is $2, then the value of a dollar (1/P) is half a cone) (Price level measures the value in money)

below

If the price level is _____ the equilibrium level, people will want to hold less money than the Fed has created, and the price level must rise to balance supply and demand. (Supply and Demand) (In the long run, money supply and money demand are brought into equilibrium by the overall level of prices.)

above

If the price level is ______ the equilibrium level, people will want to hold more money than the Fed has created, so the price level must fall to balance supply and demand. (Supply and Demand) (In the long run, money supply and money demand are brought into equilibrium by the overall level of prices.)

long run

In the ____ ____, money supply and money demand are brought into equilibrium by the overall level of prices. (Supply and demand)

unexpected inflation

Inflation has another cost, however, when it comes as a surprise. (A hyperinflation enriches Sophie at the expense of Bigbank because it diminishes the real value of the debt; Sophie can repay the loan in dollars that are less valuable than she anticipated. Deflation enriches Bigbank at Sophie's expense because it increases the real value of the debt; in this case, Sophie has to repay the loan in dollars that are more valuable than she anticipated.)

taxes

Many _____, however, become even more problematic in the presence of inflation. The reason is that lawmakers often fail to take inflation into account when writing the tax laws. Economists who have studied the tax code conclude that inflation tends to raise the tax burden on income earned from savings.

money demand

Most fundamentally, the demand for money reflects how much wealth people want to hold in liquid form. Many factors influence the quantity of money demanded. The amount of currency that people hold in their wallets, for instance, depends on how much they rely on credit cards and how easily they can find an automatic teller machine. (the quantity of money demanded depends on the interest rate that a person could earn by using the money to buy an interest-bearing bond rather than leaving it in his wallet or low-interest checking account.)

goods and services

People try to get rid of this excess supply of money in various ways. They might use it to buy goods and services. Or they might use this excess money to make loans to others by buying bonds or by depositing the money in a bank savings account. These loans allow other people to buy goods and services. In either case, the injection of money increases the demand for _____ ___ _______.

quantity theory of money

Prices rise when the government prints too much money (Inflation and hyper inflation) (Most economists today rely on this theory to explain the long-run determinants of the price level and the inflation rate) (Known as classical because it was developed by some of the earliest economic thinkers)

real interest rate

The ____ _________ ____ 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. The real interest rate is the nominal interest rate minus the inflation rate:

nominal interest rate

The _______ _______ ____ is the interest rate you hear about at your bank. If you have a savings account, for instance, the nominal interest rate tells you how fast the number of dollars in your account will rise over time (nominal interest rate is the sum of the real interest rate and the inflation rate:)

not change

The economy's ability to supply goods and services does ___ ______ when there's an injection of money. (As we saw in the chapter on production and growth, the economy's output of goods and services is determined by the available labor, physical capital, human capital, natural resources, and technological knowledge. None of these is altered by the injection of money)

price level

The greater demand for goods and services causes the _____ _____ to increase. The increase in the price level, in turn, increases the quantity of money demanded because people are using more dollars for every transaction.

inflation

The increase in the overall level of prices. "Public Enemy number one" (Inflation is an economy-wide phenomenon that concerns, first the foremost, the value of the economy's medium of exchange)

Real GDP

____ ___ is a real variable because it measures the total quantity of goods and services produced and is not influenced by the current prices of those goods and services.

real interest rate

____ _______ ____ is a real variable because it measures the rate at which people exchange goods and services today for goods and services in the future.

Real wage

____ ____is a real variable because it measures the rate at which people exchange goods and services for a unit of labor.

Nominal GDP

_______ ___ is a nominal variable because it measures the dollar value of the economy's output of goods and services

Relative price

________ _____ is not measured in terms of money. When comparing two goods, the dollar signs cancel and the resulting number is measured in physical units. (Example: we could say that the price of a bushel of corn is bushels of wheat.)

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.

inflation rate

according to the quantity theory of money, growth in the money supply determines the _________ ____.

creditors and debtors

deflation is rarely as steady and predictable as Friedman recommended. More often, it comes as a surprise, resulting in the redistribution of wealth toward creditors and away from debtors. Because debtors are often poorer, these redistributions in wealth are particularly painful.