Chapter 15: Inflation

Question 1

Define ‘Inflation’.

Answer 1

An overall rise in prices in the economy.
Short run: caused by business cycle.
Long run: caused by increases in money supply.

Question 2

Define ‘Deflation’.

Answer 2

An overall fall in prices in the economy.
Considered more dangerous than inflation.
When prices are falling, deflation makes debt more expensive over time, making it harder to pay back. High default rates, in turn, lower prices, causing further defaults. Leads to deflationary spiral, halting economy.

Question 3

Define ‘Core inflation’.

Answer 3

Measure of inflation that excludes goods with historically volatile price changes.

Question 4

Define ‘Aggregate price level’.

Answer 4

A measure of the average price level; in practice, the CPI or GDP price deflator.

Question 5

Define ‘Neutrality of money’.

Answer 5

The idea that aggregate price levels do not affect real variables in the economy.
I.e. if the money supply suddenly doubled, nGDP would double, but rGDP would remain the same.

Question 6

Define ‘Quantity theory of money’.

Answer 6

Theory that the value of money (in terms of output we can buy) is determined by the overall quantity of money in existence (the money supply).

Question 7

Define ‘Velocity of money’.

Answer 7

The number of times the entire money supply turns over in a given period.

Question 8

Define ‘Menu costs’.

Answer 8

The costs (measure in money, time, and opportunity) of changing prices to keep pace with inflation.

Question 9

Define ‘Shoe-leather costs’.

Answer 9

The costs (measure in time, money, and effort) of managing cash in the face of inflation.

Question 10

Define ‘Nominal interest rate’.

Answer 10

The reported interest rate, not adjusted for the effects of inflation.

Question 11

Define ‘Real interest rate’.

Answer 11

The interest rate adjusted for the effects of inflation.

Real interest rate = nom. interest rate - inflation rate

Question 12

Define ‘Disinflation’.

Answer 12

A period in which inflation rates are falling, but still positive.
A famous example was Gerald Bouey’s efforts to tem inflation in the 1980s.

Question 13

Define ‘Hyperinflation’.

Answer 13

Extremely long-lasting and painful increases in the price level.
Can cause economic crisis and drastically reduce the value of a country’s currency.

Question 14

Define ‘Potential output’.

Answer 14

The total amount of output a country could produce if all of its resources were fully engaged.

Question 15

Define ‘Output gap’.

Answer 15

The difference between actual and potential output in an economy.

Question 16

Define ‘Phillips curve’.

Answer 16

A model that shows the connection between inflation and unemployment in the short run.
The curve shows that a decrease in unemployment will be accompanied by an increase in inflation in the short run. The relationship does not hold over long run, in part because of inflation expectations.

Question 17

Define ‘Non-accelerating inflation rate of unemployment (NAIRU)’.

Answer 17

The lowest possible unemployment rate that will not cause the inflation rate level to increase.
Also known as full employment.

Question 18

The neutrality of money suggest that the money supply affects price levels throughout the economy, but in the long run…?

Answer 18

In the long run has no effect on real variables in the economy, such as output.

Question 19

Describe the classical theory of inflation in the long run.

Answer 19

The classical theory of inflation describes the relationship between the money supply, output, and the price level. The theory argues that the money supply has no effect on output in the long run.

Question 20

Describe the classical theory of inflation in the short run.

Answer 20

In the short run, adjusting the money supply can change output. If the central bank adopts expansionary policy, it could increase the money supply, shifting the AD curve to the right and causing output and prices to increase.
Then, the effect on the cost of production and anticipation that high prices will continue causes AS curve to shift leftward until it intersects AD at original output.

Question 21

According to the quantity theory of money, changes in the quantity of money affect the price level. An increase in the money supply leads to ___; a decrease to ___.

Answer 21

Inflation.

Deflation.

Question 22

What is the equation for the quantity theory of money?

Answer 22

M x V = P x Y

Money supply (total spending)) x (Velocity of money) = (Price level) x (Real output (nGDP)

Question 23

What happens if inflation rates are unstable?

Answer 23

If inflation rates are unstable, they introduce uncertainty into the market, often causing a decline in output.

Question 24

What costs can be imposed, even by stable rates of inflation?

Answer 24

Menu costs and bracket creep.

Question 25

The central bank uses monetary policy to control inflation. Central banks prefer to keep inflation low, but positive. When full employment occurs, the economy is said to be producing at its potential output, the total amount of output a country can produce if its recourses are used efficiently. The output gap is the difference between pot. and actual output. What happens when the gap is negative? Positive?

Answer 25

When the output gas is negative, inflation will decrease. Central banks will then pursue expansionary monetary policy by lowering interest rates, allowing inflation to rise and bringing back full employment.
When the gap is positive, inflation will increase.

Question 26

If central banks pursue aggressive expansionary policy to reduce unemployment, what will happen?

Answer 26

Inflation may spiral out of control.