Chapter 11 Flashcards
What do economists believe about the quantity theory of money?
It’s a good explanation of the long run behaviour of inflation
The quantity theory of money
Used to explain the long-run determinants of the price level and the inflation rate
Inflation
An increase in the overall level of prices
Define :Hyperinflation.
Inflation at over what rate?
An extraordinarily high rate of inflation.
Inflation exceeding 50% per month.
Deflation
Decreasing average prices
Over the past 60 years, prices have risen on average about __ % per year
4
Define: An economy-wide phenomenon that concerns the value of the economy’s medium of exchange
Inflation
When the overall price level rises, what happens to the value of money?
Its value falls
What does P stand for?
The price of a basket of goods, measured in money (Price level)
What is the value of $1, measured in goods? (equation)
1/P
Inflation drives up _____ and drives down __________
Prices
The value of money
What does the quantity theory of money assert?
That the quantity of money determines the value of money
What are the two approaches to the quantity theory of money?
- A supply-demand diagram
2. An equation
In the money supply-demand model, we assume that BoC controls what?
Controls the money supply and sets it at some fixed amount
What is money demand (MD)?
Refers to how much wealth people want to hold in liquid form
What does money demand depend on?
Depends on the price level (P)
An increase in P _____ the value of money, so ____ money is required to buy g&s
Reduces
More
Thus, quantity of money demanded is positively /negatively related to the value of money and positively/negatively related to P, other things equal
Negatively
Positively
What happens when the value of money rises?
The price level falls
The Bank of Canada sets money supply (MS) at some fixed value, regardless of what?
The price level (P)
A fall in the value of money leads to an increase/decrease in P?
Increase
A fall in value of money increases the quantity of money demanded.
True
The price level (P) adjusts to equate what?
The quantity of money demanded with the money supply
If the BoC increases the money supply, what happens to the value of money (1/P) and the price level (P)?
The value of money falls
The price level rises
Increase in money supply causes the value of money (1/P) to rise.
False, it causes the price level (P) to rise
How do people get rid of their excess money? What’s the result?
By spending it on goods and services OR by loaning it to others (who spend it)
Result: increased demand for goods
(supply of goods does not increase, so price must rise)
Nominal variables
Measured in monetary units
Three examples of nominal variables
Nominal GDP Nominal interest rate (rate of return measured in $) Nominal wage ($/ hour worked)
Real variables
Measure in physical units
Three examples of real variables
Real GDP Real interest rate (measured in output) Real wage (measured in output)
Relative price
The price of one good relative to (divided by) another
*= (X/Y) = Y per X
Relative prices are measured in physical units, so they are nominal variables.
False, so they are nominal variables
Whats an important relative price?
The real wage
What is real wage?
The price of labour relative to the price of output
= W/P
= hour/ unit of output
What is the variable for nominal wage (or price of labour)?
W
Classical dichotomy?
The theoretical separation of nominal and real variables
Hume and the classical economists
suggested that monetary developments
affect real variables but not nominal variables.
False
Nominal
Real
If the central bank doubles the money supply, Hume & classical thinkers contend what about the nominal and real variables?
Nominal variables - will double, including prices
Real variables - will remain unchanged, including relative prices
What is the proposition that changes in the money supply do not affect real variables?
Monetary neutrality
Doubling money supply will cause all nominal and relative prices to double. (under monetary neutrality)
False, relative price is unchanged
Doubling money supply will cause all nominal prices to double. Then what will happen to the real wage in monetary neutrality?
The real wage will remain unchanged
So.. the quantity of labour supplied, demanded, and the total employment of labour do NOT change
Since employment of all resources is unchanged, total output is also unchanged by the money supply.
True
In monetary neutrality, what will happen to employment of capital and other sources?
They will remain unchanged
Most economists believe the classical dichotomy and neutrality of money describe the economy in the short run.
False, long run
Velocity of money
The rate at which money changes hands
What does P x Y equal?
= nominal GDP
OR = (price level)x(real GDP)
Whats does M mean? V?
M = money supply V = velocity
What is the velocity formula?
V = (P x Y) / M
What is the quantity equation?
M x V = P x Y
Which variable is stable in the quantity theory?
Velocity (V) is stable
Quantity theory - A change in M causes _____
to change by the same percentage
Nominal GDP (P x Y)
Why DOESN’T a change in the money supply (M) affect real GDP (Y)?
Cause money is neutral, and real GDP is determined by technology & resources
The price level changes by the same % as what ? (2)
- Nominal GDP (P x Y)
2. Money supply (M)
What does rapid money growth cause?
Rapid inflation
If real GDP is constant, then inflation rate = money growth rate.
True
If real GDP is growing, then
inflation rate > money growth rate.
False.
inflation rate < money growth rate.
Economic growth increases/ decreases the # of transactions. The transactions need?
Increases
Needs money growth
When might the governement print money to pay for its spending?
When tax revenue is inadequate and the ability to borrow is limited
Inflation tax
The revenue from printing money
Printing money causes inflation, which is like a tax on everyone who holds money
Nominal interest rate =
Inflation rate + Real interest rate
How is the real interest rate determined?
By saving & investment in the loanable funds market
How is inflation rate determined?
By the money supply growth
In the long run, money is neutral, so a change in the money growth rate affects
_____ but not _______
The inflation rate
Real interest rate
Fisher effect
An increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate (on wealth) is unchanged.
The inflation tax applies to people’s holdings of _____, not their holdings of ______.
Money
Wealth
What its called when most people think inflation erodes real incomes?
Inflation fallacy
What is a general increase in prices of the things people buy and the things they sell?
Inflation
In the long run, what are real incomes determined by?
Real variables
Shoeleather costs
The resources wasted when inflation encourages people to reduce their money holdings
What do shoeleather costs include?
The time and transaction cpsts of more frequent bank withdrawls
Menu costs
The costs of changing prices
Examples of menu costs
printing new menus, mailing new catalogs, etc.
Define: Firms don’t all raise prices at the same time, so relative prices can vary… which distorts the allocation of resources.
Misallocation of resources from relative-price variability
Define : Inflation changes the yardstick we use to measure transactions. Which complicates long-range planning and the comparison of dollar amounts over time
Confusion & inconvenience
Tax distortions
Inflation makes nominal income grow faster than real income
Taxes are based on ________, and some are/ are not adjusted for inflation.
Nominal income
Are not adjusted
Inflation causes people to pay _____ taxes
even when their real incomes _______.
More
Don’t increase
You deposit $1000 in the bank for one year.
1: inflation = 0%, nom. interest rate = 10%
2: inflation = 10%, nom. interest rate =20%
Assume the tax rate = 25%
a) In which case does the real value of your deposit grow the most?
In both cases, the real interest rate is 10%,
so the real value of the deposit grows 10%
(before taxes)
You deposit $1000 in the bank for one year.
1: inflation = 0%, nom. interest rate = 10%
2: inflation = 10%, nom. interest rate =20%
Assume the tax rate = 25%
b) In which case do you pay the most taxes?
1: interest income = $100, pay $25 in taxes.
2: interest income = $200, pay $50 in taxes.
You deposit $1000 in the bank for one year.
1: inflation = 0%, nom. interest rate = 10%
2: inflation = 10%, nom. interest rate =20%
Assume the tax rate = 25%
Compute the after-tax nominal interest rate, then subtract off inflation to get the after-tax real interest rate for both cases.
1: nominal = 0.75 x 10% = 7.5%
real = 7.5% – 0% = 7.5%
2: nominal = 0.75 x 20% = 15%
real = 15% – 10% = 5%
Inflation raises nominal interest rates and also the real interest rates.
False. Inflation raises nominal interest rates (Fisher effect) but not real interest rates
Inflation decreases savers’ tax burdens.
False. Increases
Inflation lowers/raises the after-tax real interest rate.
Lowers
Debtors
Get to repay their debt with dollars that aren’t worth as much
Arbitrary redistributions of wealth
Higher-than-expected inflation transfers
purchasing power from creditors to debtors
Lower-than-expected inflation transfers purchasing power from creditors to debtors.
False. Debtors to creditors
High inflation is more variable and less predictable than low inflation.
True
________________________ are frequent
when inflation is high.
Arbitrary redistributions of wealth
money is _____ in the ______ run, affecting only nominal variables
Money
Long run
According to the quantity of money theory,
the _______ depends on the quantity of money, and the _______ depends on the money growth rate.
Price level
Inflation rate
The classical dichotomy is the division of variables into ______. Long or short run?
real & nominal
Economists say Long run
The neutrality of money is the idea that changes in the money supply affect ______ but not ________ Long or short run?
Nominal variables, but not real ones.
Economists say long run
The inflation tax is the ____ in the real value of people’s _______ when the government causes inflation by _________
Loss
Money holdings
Printing money
The Fisher effect is the one-for-one relation between?
Changes in the inflation rate and changes in the nominal interest rate
What do the costs of inflation include?
menu costs, shoeleather costs, confusion and inconvenience, distortions in relative prices and the allocation of resources, tax distortions, and arbitrary redistributions of wealth
