#5 Inflation Flashcards
The classical Theory of Inflation
Assumes prices are flexible and market is clear
Applies to long run
The quantity theory of money
Linking inflation rate to the growth rate of the money supply
The quantity theory of money begins with…
The concept theory of velocity
Velocity basic concept
The rate at which money circulates
Velocity
The number of times the average dollar bill changes hands in given time period
Velocity equation
V = T / M
V - velocity
T - value of all transactions
M - money supply
Velocity function n2
V = PY / M
P - price of output (GDP deflator)
Y - quantity of output (Real GDP)
PY - value of output (Nominal GDP)
Quantity equation
MV = PY
Real money balances
The purchasing power of the money supply
M / P
Simple money-demand function
( M / P ) ^d = KY
K - how much money ppl wish to hold for each $ of income (exogenous)
Connection between Quantity Equation and Money Demand
K = 1 / V
When ppl hold lots of money relative to their income…
K is large, money changes hands infrequently —> V is small
How the price level is determined:
- Money supply determines nominal GDP (PY) (M)
- Real GDP is determined by economy’s supplies of K and L and the production function
- The price level is P = Nominal GDP / Real GDP
The quantity theory of Money
/\ = 🔺M / M - 🔺Y / Y
/\ —> pi
*
*
🔺Y/Y
Depends on growth in the factors of production and on technological progress
The quantity theory predicts…
One-for-one relationship between changes in the money growth rate and changes in the inflation rate
Seigniorage
The revenue raised from money creation
The inflation tax
Money creation to raise revenue can cause inflation, paid by holders of money and other nominal assets
Nominal interest rate i and inflation
Not adjusted for inflation
Real interest rate r and inflation
adjusted for inflation
Fisher effect equation
i = r + /\
Fisher effect
Increase in /\ causes equal increase in i, this one-for-+e relationship is called Fisher Effect
