Chapter 11

Question 1

Inflation and Deflation

Answer 1

What determines whether an economy experiences inflation and, if so, how much?
* Inflation is an increase in the overall level of prices.
* Deflation is a fall in the overall level of prices.

Question 2

Inflation Rate is % Change in either?

Answer 2

The inflation rate is the percentage change in either the
* CPI
* GDP deflator
* other index of the overall price level

These price indexes show that, over the past 70 years, prices have risen on average about 4 percent per year.

Accumulated over so many years, a 4 percent annual inflation rate leads to a 16-fold increase in the price level.

Question 3

THE CLASSICAL THEORY OF INFLATION: Quantity Theory of Money Intro

Answer 3

The quantity theory of money will be used to understand inflation.

It is often called classical because it was developed by some of the earliest thinkers about economic issues.

Most economists today rely on this theory to explain the long-run determinants of the price level and the inflation rate.

Question 4

THE CLASSICAL THEORY OF INFLATION: Level of Price and Value of Money

Answer 4

The Level of Prices and the Value of Money:

The economy’s overall price level can be viewed in two ways:
* as the price of a basket of goods and services.
* as a measure of the value of money.

Question 5

Money Supply, Money Demand, and Monetary Equilibrium

Answer 5

The value of money is determined by the supply and demand for money.

The supply of money is controlled by the Bank of Canada and the banking system.

The demand for money reflects how much people will want to hold in liquid form.

The demand for money is sometimes referred to as “liquidity preference.”

Money is the most liquid. If interest is high, we deposit money at financial institutions. If interest rates are low, we don’t deposit money.

Question 6

Money Supply, Money Demand, and Monetary Equilibrium (Part 2)

Answer 6

Many factors affect the demand for money.
* For example, the amount of currency that people hold in their wallets can depend on how much they rely on credit cards or the accessibility of ATMs.

The most important variable that explains the demand for money is the level of prices in the economy.

In the long run, the overall level of prices adjusts to the level at which demand for money equals the supply.

Question 7

FIGURE 11.1 How the Supply and Demand for Money Determine the Equilibrium Price Level

Answer 7

Graph with money supply vertically up and a slope from top left to bottom right being the money demand

The horizontal axis shows the quantity of money.

The left vertical axis shows the value of money, and the right vertical axis shows the price level.

The demand curve for money is downward sloping because people want to hold a larger quantity of money when each dollar buys less

Question 8

THE CLASSICAL THEORY OF INFLATION: Effects of Monetary Injection Part 2

Answer 8

This explanation of how the price level is determined and why it might change over time is called the quantity theory of money.

Quantity theory of money is a theory that says the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate.

Question 9

FIGURE 11.2 An Increase in the Money Supply (Monetary Injection)

Answer 9

When the Bank of Canada increases the supply of money, the money supply curve shifts from MS1 to MS2.

The value of money (on the left axis) and the price level (on the right axis) adjust to bring supply and demand back into balance.

The equilibrium moves from point A to point B.

Thus, when an increase in the money supply makes dollars more plentiful, the price level increases, making each dollar less valuable.

Question 10

THE CLASSICAL THEORY OF INFLATION: A Brief Look at the Adjustment Process

Answer 10

How does the economy get from the old to the new equilibrium?
1. A monetary injection creates an excess supply of money. (Supply goes up)
1. At the prevailing price level, the quantity of money supplied now exceeds the quantity demanded. (People have more money than they need so they spend it)
1. The injection of money increases the demand for goods and services while supply remains unchanged. (People spending money creates more demand for the goods and services they spend money on)
1. The prices of goods and services increase. (More demand on those goods and services makes the prices go up of those goods and services)
1. The quantity of money demanded increases until the the economy reaches a new equilibrium. (People now need more money to buy things and the demand of money goes up causing the balance of demand and supply again)

Question 11

THE CLASSICAL THEORY OF INFLATION: The Classical Dichotomy and Monetary Neutrality

Answer 11

Economic variables can be divided into two groups:
1. Nominal variables are variables measured in monetary units.
1. Real variables are variables measured in physical units.

Classical dichotomy: The theoretical separation of nominal and real variables.

Monetary neutrality is the proposition that changes in the money supply do not affect real variables.

Question 12

THE CLASSICAL THEORY OF INFLATION: Velocity Equation

Answer 12

How many times per year is the typical dollar used to pay for a newly produced good or service?

Velocity of money is the rate at which money changes hands.

V = (P x Y) / M

V: Velocity of money
Y: Real GDP
P: Price level
M: Quantity of money

Question 13

THE CLASSICAL THEORY OF INFLATION: Quantity Equation Part 2

Answer 13

Quantity equation is the equation that relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services.

M x V = P x Y

Question 14

THE CLASSICAL THEORY OF INFLATION: Velocity and the Quantity Equation Part 3

Answer 14

The elements that explain the equilibrium price level:
1. Velocity (V) is stable over time.

1. Because V is stable, when the central bank changes the quantity of money (M), it causes proportionate changes in the nominal value of output (P × Y).
2. The economy’s output of goods and services (Y) is primarily determined by factor supplies and technology. In particular, because money is neutral, money does not affect output.
3. With output (Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P × Y), these changes are reflected in changes in the price level.
4. Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.

Basically saying that V is stable, so only M can change on that side of the equation. Since M is change in money it does not affect production (Y), so any change in M directly changes Price (P) by the same amount

Question 15

FIGURE 11.3 Nominal GDP, the Quantity of Money, and the Velocity of Money

Answer 15

This figure shows the nominal value of output as measured by nominal GDP, the quantity of money as measured by M2, and the velocity of money as measured by their ratio.

For comparability, all three series have been scaled to equal 1 in 1980.

As suggested by the quantity theory, the relative rates of growth in nominal GDP and the money supply mean that the velocity of money fell in value during this period, particularly since 2008.

You can see the velocity is pretty stable, it just goes around the bottom. A nominal GDP is in the middle and the money supply is the highest.

Question 16

FIGURE 11.4 Money and Prices during Four Hyperinflations

Answer 16

This figure shows the quantity of money and the price level during four hyperinflations.

In each case, the quantity of money and the price level move closely together.

The strong association between these two variables is consistent with the quantity theory of money, which states that growth in the money supply is the primary cause of inflation.

Remember, money supply causes price to go up. Price going up is the cause of inflation. So price level and money supply move together.

Question 17

THE CLASSICAL THEORY OF INFLATION: The Inflation Tax

Answer 17

Inflation tax is the revenue the government raises by creating money.

The inflation tax is not exactly like other taxes, however, because no one receives a bill from the government for this tax. The inflation tax is more subtle.

When the government prints money, the price level rises, and the dollars in your pocket are less valuable.

Think of it like this. When the government prints money and that equilibrium moves, to that new equilibrium. The value of your money lowers and the price goes up (left side and right side of grpah), so inflation goes up and the value for money lowers. So each dollar in your pocket is now worth less. They are less valuable, which in itself is kind of an inadvertent tax.

Question 18

THE CLASSICAL THEORY OF INFLATION: The Fisher Effect

Answer 18

The Fisher Effect:

Real Interest Rate = Nominal Interest Rate - Inflation Rate

Nominal Interest Rate = Real Interest Rate + Inflation Rate

Fisher effect is the one-for-one adjustment of the nominal interest rate to the inflation rate.

It’s as simple as if inflation goes up 10%, nominal interest goes up 10%.

Question 19

FIGURE 11.5 The Nominal Interest Rate and the Inflation Rate

Answer 19

This figure uses annual data since 1968 to show the nominal interest rate on three-month corporate bonds and the inflation rate as measured by the consumer price index.

The close association between these two variables over the long run is evidence for the Fisher effect: When the inflation rate rises, so does the nominal interest rate.

Question 20

THE COSTS OF INFLATION: A Fall in Purchasing Power? The Inflation Fallacy

Answer 20

Inflation does not in itself reduce people’s real purchasing power.

If nominal incomes (salary) tend to keep pace with rising prices, inflation is not a problem.

There are, however, costs associated with inflation.

Question 21

THE COSTS OF INFLATION 1 and 2: Shoeleather Costs and Menu Costs

Answer 21

Shoeleather Costs
Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings.

How can you avoid inflation tax? Take money in lower amount more frequently, this makes your money grow more but you need to give more time to walk back and forth. This leads to give up time in order to avoid inflation tax.

Menu Costs
Menu costs are the costs of changing prices. Changing prices for a restaurant costs money. Businesses change prices infrequently because there are costs of changing prices.

Question 22

THE COSTS OF INFLATION 3: Relative-Price Variability and the Misallocation of Resources

Answer 22

Because prices change only once in a while, inflation causes relative prices to vary more than they otherwise would.

This issue is important because in market economies, we rely on relative prices to allocate scarce resources.

Think of Bungalow example, as we give more demand to bungalows there prices go up which for conusmer is bad but for builder is good as they now let the conusmer decide where they should use resources and that is to build bungalows.

Question 23

THE COSTS OF INFLATION 4: Inflation-Induced Tax Distortions

Answer 23

Inflation tends to raise the tax burden on income earned from savings.

• Inflation discourages saving by the tax treatment of capital gains.
• The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.

IBM stock example:
Buy stock for $10 in 90’s
Sell stock for $140 in 2019

If you do the math your $10 bucks is $50 bucks today so logically you made $90 bucks and should get taxed for $90 bucks.

Instead you get taxed for $130 as they see it as $10 turned into $140

This causes a tax burden for this type of income.

Question 24

Active Learning Example

Answer 24

A key take away here is inflation:
Raises nominal interest rates, but not real interest rates. Remember the Fisher effect
Increase the savers tax burdens. Remember that IBM example?
And lowers the after tax real interest rate. (Nominal - Inflation = Real)

Question 25

THE COSTS OF INFLATION 5: Confusion and Inconvenience

Answer 25

Money is the ruler with which we measure economic transactions.

The job of the BoC is a bit like the job of Measurement Canada.

The BoC ensures the reliability of a commonly used unit of measurement.

When the Bank of Canada increases the money supply and creates inflation, it erodes the real value of the unit of account. Making it difficult to judge costs.

Question 26

THE COSTS OF INFLATION: A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth

Answer 26

Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.

These redistributions occur because many loans in the economy are specified in terms of the unit of account: MONEY.

Consider an example. Sam picks out $20,000 loan at 7% interest from big bank to expand his business.

In 10 years, the loan will come due after his debt has compounded for 10 years at 7%. Sam owes Big Bank $40,000.

The real value of is that will depend on inflation. Over a decade, if Sam is lucky, the economy will have a hyperinflation. In this case wages and prices will rise so that Sam will be able to the 40,000 debt out of pocket change.

By contrast, if the economy goes through a major deflation, the wages and prices will fall in. Sam will find the $40,000 debt a greater burden than he anticipated.

Question 27

THE COSTS OF INFLATION: Inflation Is Bad, But Deflation May Be Worse

Answer 27

Some of the costs of deflation mirror those of inflation.

Menu costs

Relative-price variability

Redistribution of wealth toward creditors and away from debtors

A sign of broader macroeconomic difficulties

Deflation is often a symptom of deeper economic problems.