Chapter 5 - Inflation

Question 1

Velocity

Answer 1

The number of times the average dollar bill changes hands in a given period of time. It is non-observable (must be calculated using quantity equation).

Question 2

Why do we use nominal GDP (P*Y) instead of total value of all transactions (T) in the quantity equation.

Answer 2

It is difficult to find the value of all transactions in the economy. Nominal GDP is close to the total value of all transactions (some transactions such as sale of used goods not included in nGDP).

Question 3

Quantity Equation

Answer 3

MV = PY
(An identity)

Question 4

Real Money Balances

Answer 4

= M/P
The purchasing power of the money supply

(M/P)d = kY

Question 5

k (Real Money Balances Equation)

Answer 5

k = 1/V
How much money people wish to hold for each dollar of income (k is exogenous)

Question 6

Inflation Rate Equation (Quantity Theory of Money)

Answer 6

Inflation = change in M - change in Y

Question 7

Why does the inflation rate depend on money growth?

Answer 7

Normal economic growth requires a certain amount of money growth to facilitate the growth in transactions.

Question 8

Ideally, what is the best way to minimize inflation? What is the issue of minimizing inflation optimally?

Answer 8

Adjust the money supply (increase/decrease) so inflation = 0. However, money growth rate is not known so the Bank of Canada must predict the economic growth and adjust money growth so inflation = 0.

Question 9

What does economic growth (change in Y) depend on?

Answer 9

Growth in the factors of production (K, L)
Technological Progress

Question 10

Fisher Effect

Answer 10

i = r + pi
(Nominal Interest Rate = Real Interest Rate + Inflation Rate)

Question 11

ex ante real interest rate

Answer 11

Real interest rate people expect at the time they buy a bond or take out a loan

Question 12

ex post real interest rate

Answer 12

The real interest rate actually realized

Question 13

What is the opportunity cost of holding money?

Answer 13

Nominal interest rate (interest that could be earned by depositing money)

Question 14

What are the 2 determinants of money demand?

Answer 14

Income (Y): positive relationship with money demand (more spending on goods and services requires more money in the economy).
Nominal interest rate (i): negative relationship with money demand (people hold less money when interest rates are high)

(M/P)d = L(i, Y)

Question 15

Why is expected inflation assumed to be equal to actual inflation in the long run?

Answer 15

People don’t consistently over-forecast or under-forecast inflation in the long run (sometimes overestimate, sometimes underestimate).