9 Inflation

Question 1

Define inflation

Answer 1

The percentage change in an economy’s overall price level over time.

Question 2

Define hyperinflation

Answer 2

Episodes of extremely high inflation - e.g. over 500%.

Question 3

Define monetary base

Answer 3

A measure of money that includes currency as wall as accounts that private banks hold with an economy’s central bank, which pay no interest. These accounts are called reserves.

Question 4

Define M1 and M2

Answer 4

M1: A measure of money that includes currency and adds “demand deposits” like checking accounts.

M2: Like M1 also includes savings deposits and individual money market accounts.

Question 5

What is the quantity theory of money equation?

Answer 5

Question 6

What does the right hand side denote?

Answer 6

Nominal GDP - the amount of goods and services purchased in the economy per year, at current prices.

Question 7

What does the left hand side denote?

Answer 7

It is the amount of money in circulation multiplied by how frequently that money switches hands.

The effective amount of money used in purchases.

Question 8

What is the velocity of money?

Answer 8

The velocity of money is thought as the average number of times per year that each piece of paper currency is used in a transaction.

Question 9

What is the classical dichotomy?

Answer 9

An assumption that states that in the long run the real and nominal sides of the economy are completely separate.

Real GDP determined solely by real considerations.

Question 10

How does this dichotomy change our equation?

Answer 10

Question 11

Assumptions of the classical dichtomy

Answer 11

Question 12

Equation for the price level using the quantity theory

Answer 12

Question 13

Quantity theory of money: 4 equations, 4 unknowns

Answer 13

Question 14

How can we apply the quantity theory of money to inflation rate?

Answer 14

Question 15

Define deflation

Answer 15

Sustained negative inflation

Question 16

What is the neutrality of money? Is this true in the short-run?

Answer 16

The proposition that changes in the money supply have no real effects on the economy and only affect prices.

Not necessarily true in the short-run due to time delays. Nominal prices do not respond immediately and precisely so this could affect the real economy over short horizons.

Question 17

Recall: what is the real interest rate equal to?

Answer 17

The marginal product of capital.

Question 18

Define nominal interest rate

Answer 18

The interest rate paid on savings accounts paid in currency rather than goods.

Question 19

What is the Fisher equation?

Answer 19

Question 20

What costs are associated with inflation?

(3)

Answer 20

Distortion of relative prices: some goods’ prices adjust better to changes in inflation that others’.

Shoe-leather costs: High inflation → frequent visits to the bank to take out money.

Menu costs: costs to firms of changing prices, high inflation → lots of frequent necessary changes to price.

Question 21

Why do banks often print lots of money?

Answer 21

To cover government debt.

Question 22

What is the government budget constrain equation?

Answer 22

Question 23

Who pays the inflation tax?

Equity?

Answer 23

Inflation tax shows up as a decrease in the value of money, those holding currency essentially pay for it through higher price levels.

Although, people that hold their wealth in tangibles such as land or other capital are not affected so much by the rise in price level as the real value of their wealth has not changed, thus it primarily impacts those that store wealth in currency in the bank - usually poorer individuals.

Question 24

Why do we have central bank independence?

Answer 24

It is an attempt to prevent fiscal considerations from leading to excessive inflation. Inhibits temptation of governments to print more money to cover debts.

Question 25

Define seignorage

Answer 25

Also known as the inflation tax, it is the revenue the government obtains by issuing new money ΔM.