Chapter 11 Flashcards
What is inflation?
Inflation is the increase in the overall level of prices in an economy.
What is deflation?
Deflation is the decrease in the overall level of prices in an economy.
What is hyperinflation, and when does it occur?
Hyperinflation occurs when inflation exceeds 50% per month, often due to excessive money printing by governments.
What are nominal variables vs. real variables?
Nominal variables are measured in monetary units (e.g., wages, prices, nominal GDP). Real variables are measured in physical units (e.g., real wages, relative prices, real GDP).
What is monetary neutrality, and does it hold in the short run?
Monetary neutrality is the idea that changes in the money supply affect only nominal variables, not real variables. It holds in the long run but not in the short run.
What does the quantity theory of money state?
The quantity theory of money states that changes in the money supply lead to proportional changes in the price level, assuming velocity is constant.
What is the quantity equation?
𝑀 × 𝑉 = 𝑃 × 𝑌 where: M = Money supply, V = Velocity of money, P = Price level, Y = Real GDP.
If the money supply grows by 10%, what happens to inflation if real GDP remains constant?
Inflation also increases by 10% because of the quantity theory of money.
What happens if the velocity of money increases?
If velocity (V) increases, nominal GDP increases, leading to higher prices and inflation.
How does the Bank of Canada control inflation using the quantity theory of money?
To lower inflation: The Bank reduces the money supply by selling bonds or increasing interest rates. To increase inflation: The Bank increases the money supply by buying bonds or lowering interest rates.
What are the six main costs of inflation?
Shoeleather costs – More frequent trips to the bank to withdraw cash. Menu costs – The cost of changing prices (e.g., reprinting catalogs). Increased variability of relative prices – Prices change at different rates, distorting markets. Unintended tax distortions – Inflation increases tax burdens on savings and capital gains. Confusion & inconvenience – Harder to compare prices over time. Arbitrary redistribution of wealth – Unexpected inflation benefits borrowers and hurts lenders.
What is the inflation tax?
The inflation tax occurs when the government prints money to finance spending, reducing the purchasing power of existing money.
What is the Fisher Effect?
The Fisher Effect states that nominal interest rates rise one-for-one with expected inflation: Nominal interest rate = Real interest rate + Inflation rate.
If the inflation rate is 3% and the real interest rate is 4%, what is the nominal interest rate?
Nominal interest rate = 4% + 3% = 7%.
What happens if inflation is higher than expected?
Borrowers gain, and lenders lose because the real value of loan repayments decreases.
What happens if inflation is lower than expected?
Lenders gain, and borrowers lose because loan repayments have higher real value.
Scenario: The Bank of Canada suddenly increases the money supply. What happens to inflation and interest rates in the short and long run?
Short run: Lower interest rates, higher spending, temporary economic growth. Long run: Higher inflation, higher nominal interest rates due to the Fisher Effect.
Scenario: A country prints excessive money to pay for government spending. What happens?
Hyperinflation occurs as prices skyrocket, reducing the value of money.
Scenario: You deposit money in a savings account with a 5% nominal interest rate, but inflation is 3%. What is your real interest rate?
Real interest rate = 5% - 3% = 2%.
Scenario: If velocity remains constant and real GDP increases by 2%, what must happen to the money supply for the price level to remain stable?
The money supply must also increase by 2% to match GDP growth.
Why do central banks avoid setting a zero-inflation policy?
Mild inflation (2-3%) helps reduce real wage rigidity and allows monetary policy flexibility. Zero inflation can lead to deflation, which discourages spending and increases debt burdens.
Why do countries with independent central banks experience lower inflation?
Because independent central banks focus on price stability rather than financing government deficits.
If money is neutral in the long run, why do central banks still adjust the money supply?
Because in the short run, money affects employment and output, helping smooth business cycles.
How is the inflation rate calculated?
Inflation Rate = (CPI in current year - CPI in previous year) / CPI in previous year × 100.
What is the difference between anticipated and unanticipated inflation?
Anticipated inflation – Expected increases in prices, allowing wages and contracts to adjust accordingly. Unanticipated inflation – Unexpected price increases that redistribute wealth between borrowers and lenders.
How does wage indexation help workers during inflation?
Wage indexation links wages to inflation, ensuring that salaries automatically rise with price levels to maintain purchasing power.
What is the relationship between inflation and real GDP growth in the short run?
If inflation is moderate and stable, it can stimulate economic growth. If inflation is too high or unpredictable, it leads to economic uncertainty and lower growth.
Why do governments prefer moderate inflation over deflation?
Moderate inflation reduces real debt burdens and prevents wage rigidity. Deflation discourages spending, increases real debt burdens, and can lead to a recession.
