5. Money growth, Inflation, Quantity theory of money, Business Cycles Flashcards
What is the impact of inflation
- People have to pay more for goods and services
- The value of money (1/P) is reduced - quantity of goods you can buy with £1
What determines the money supply
Supply and demand
- Long run price level
- Short run interest rate is more crucial
Classical theory
Money supply:
-Determined by central bank and banking system
- Supply curve treated as vertical - variable adjusted by CB
Demand
- Amount of wealth people want to hold as money to consume
Demand depends on average prices level, P, in the economy
- If P is higher the value of money (1/P) decreases so people need more £ to buy goods and services
Simply graphed on page 27:
- Fixed basket of goods - demand for money decreasing in the value of money 1/P
- In long run, price level P adjusts to level at which demand for money equal to the supply
What is the effect of a monetary injection?
Refer to graph on page 27
- Open market operations, buying bonds (government or private)
- Or reducing reserve requirements
- Shift out in fixed money supply
- Decreased value of money
- Increased price level = inflation
Excess supply of money leads to increase in demand for goods and services
- Prices of goods and services increase, since economy’s ability to supply goods and services not affected bu money supply in long run
- Increased prices increase quantity of money demanded
- New equilibrium met
Note monetary injections do not affect real GDP, employment, interest rate, etc. in the long run
What is the quantity theory of money? What is the classical dichotomy?
Growth rate in quantity of money determines inflation rate - inflation is always and everywhere a monetary phenomenon
Classical Dichotomy:
Nominal variabbles are monetary goods e.g. pounds, dollars, euro
Real variables - physical units - quantities, relative prices, real wages, real interest rates
The classical dichotomy is a theoretical separation of nominal and real variables
- Developments in the monetary system influence nominal variables but irrelevant for explaining real variables
What is monetary neutrality?
Changes in money supply dont affect real variables - all of this depends on us looking at the long run, where output is determined by A, K and L
- Things are more complicated in the short run
What is the Fisher equation?
MV = PY
PY = pound value of economy’s outputs of goods and services (nominal GDP) - price level x output/real GDP
V = velocity of money - rate at which money changes hands in the economy
What does the fisher equation imply?
If M increases and V and Y stay constant, P must increase
- In the long run V is fairly constant
- Velocity of money remains relatively stable
- Y does not depend on nominal variablles in the long run
- Change in money supply is reflected in change in price level
- Follows if CB increases the money supply rapidly this leads to a large increase in price level P (inflation until new, higher price level reached assuming CB controls money supply)
What is the fisher effect?
Principle of money neturality - increase in rate of money growth raises the rate of inflation but does not affect any real variable:
Real interest rates = nominal interest rates - inflation rates
Nominal interest rate = real interest rate + inflation rate
Demand and supply for loanable funds determine the real interest rate, and according to the quantity theory, money growth determines inflation
- This implies the fisher effect:
” there is a one for one adjustment of nominal interest rate to inflation rate with increases/decreases in the rate of money growth”
- Doesnt hold in the short run, at least if inflation unexpected
Why is inflation important
Inflation tax:
- revenue government raises by creating (issuing) money, rather than raising taxes or selling bonds
Tax on everyone holding money:
- When government prints money
- Price level rises
- pound worth less
What are the costs of inflation
Robs people of purchasing power of hard earned pounds is a common fallacy - when prices rise, buyers pay more but wage earners also earn more too if relative prices remain the same and so inflation in itself does not reduce purchasing power
Costs:
Shoe leather:
- Encourages people to reduce money holdings to minimise costs of inflation tax
-Withdraw less at banks, but visit more often - modern cost not shoe leather, but transaction costs which can add up to be substantiail
- Basically the time and effort wasted on minimising effect of inflation
Menu cost:
- Cost of changing prices
- Inflation increases menu costs that firms must bear
Misallocation of market economies:
- Prices allocate scarce resources e.g. savings to investors
- Inflation distorts relative prices, decisions distored
- Markets less capable of allocating resources to best use
Arbitrary redistributions of wealth:
- Costs of inflation apply even when inflation steady and predictable
When unexpected:
- Wealth redistributed among population - not by merit, not by need
- Wealth from creditors to debtors when loans specified in £s - inflation reduces real value of debt, since nominal interest rate effectively too low
What is the impact of deflation? How does the CB respond?
Deflation:
- Cheaper to spend tomorrow, so deferring spending and investing
- Less produced, less consumption, etc.
- Creates downward spiral of deflation
CB responds to deflation by reducing interest but only does so much - little incentive for banks to lend out money
What is the cycle of inflation
Higher prices mean workers demand higher wages and so firms increase costs, means higher prices
Also the opposite true for a spiral of deflation
Definitions for business cycle
Recession - period of declining real incomes, rising unemployment
- Technically if 2 successive quarters of negative economic growth
Depression - severe recessions
Peak/trough, contraction/expansion
What causes variations in the business cycles?
- Shocks to the economy, changes in C and G
- External shocks e.g. geopolitical events
- Rigidities in markets
- Changes in productivity levels, monetary policy, ability to increase wages, government pollcy, irrationality
What are data concepts? What kind of concept is GDP
Stationary - time series data with constant mean value over time
Non stationary - time series data where mean value falls or rises over time
GDP is non stationary - some more stationary like unemployment
