8. Inflation and deflation Flashcards
What is hyperinflation?
If inflation is above 50% in a month or 13,000% in a year.
What is the basic principle of inflation?
In the long-run, inflation is determined by the growth rate of money supply.
What is the velocity of money?
It is the ratio of total spending in the economy to the money supply.
V = total spending / M
V = P * Y / M Total spending = nominal GDP P = Price level Y = real output P*Y = nominal GDP
What does velocity of money measure?
It measures how quickly money circulates through the economy.
It is number of how many times a dollar is spent in a year
What is the quantity equation of money?
MV = PY
Total spending (PY) in an economy equals the money supply times the velocity (MV)
What does the quantity equation of money say about inflation?
ㅠ = dM/M + dV/V - dY/Y
(d = difference/delta)
Inflation is determined by the percentage changes, or growth rates of three variables: money supply, velocity of money, and real output.
Does the relation between money growth and inflation hold in the short-run?
No, the relation between money growth and inflation only holds in the long-run.
In the short-run, there is no relation to be detected.
–> this reflects the short-run influences of expenditure and supply shocks on inflation.
What explains hyperinflation?
Government budget deficits.
Governments spend more than they get in tax income, so they cover deficits by issuing bonds.
When investors do not want to buy bonds because they fear default, the government sells the bonds the central banks causing an increase in the monetary base, money supply, and thus, inflation.
Why does this happen when bonds are sold to central banks?
Central banks are entities set up by the government. The coupon payments the central bank receive is returned to the government.
–> in effect, the central bank just creates money and gives it to the government
–> Also called printing money
–> the money the government receives is called seigniorage revenue
What are the adverse effects of high inflation?
Shoe-leather costs
Distracted firms
Relative-price variability
Income inequality
What are shoe-leather costs?
People do not want their value of cash holdings to erode.
Therefore, they try to minimize their cash holdings
Lower money holdings means that transactions become harder
They visit banks causing long lines
They buy things they do not need/want to get rid of their cash
What are distracted firms?
Firms need to push their customers to pay their bills promptly before the value of the payments erode.
At the same time, they can reduce costs by delaying payables.
Like people, firms try to minimize their cash holdings
Coping with inflation allows less time to focus on running the business
What is relative-price variability?
When inflation is high, firms raise prices.
Every firm changes prices at a different time, causing dispersion in relative prices.
Inflation increases price variations distorting consumers’ and firms’ consumption
–> causes economic inefficiency
What is income inequality?
High inflation increases inequality between rich and poor.
Poor have a larger proportion of their wealth in cash holdings
Receive wages in cash, not in bank accounts, so they do not receive interest payments
Rich have bank accounts with higher interest, other assets
Why might moderate inflation ( ~10%) be harmful?
Inflation uncertainty: Inflation variability is higher if average inflation is high. Inflation becomes less stable when it rises
–> Harder to predict future inflation
–> Causes uncertainty/risk to loan markets
–> Financial system becomes less effective in channeling funds to investors, hurting economic growth
Distortions of the tax system: Some tax codes do not take into account effects of inflation
Example: taxes on capital gains
Capital gains are taxed disregarding the effect of inflation. Taxes are on nominal gains, not real gains.
