Chapter 5 - Inflation

Question 1

What do we mean by monetary neturality?

Answer 1

The irrelevance of money for real variables - neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption. In the real world, money is approximately neutral in the long run.

Question 2

What is classical dichotomy?

Answer 2

Theoretical separation of real and nominal variables

Question 3

What is the quantity theory of money?

Answer 3

A simple theory linking the inflaiton rate to the growth rate of the money supply

Question 4

What is the quantity equation?

Answer 4

MV = PT but as T is difficult to measure:

MV = PY

We use nominal GDP as a proxy for total value of transactions (PT)

Related as the more the economy produces, the more goods are bought and sold

P = price of output (GDP deflator)
Y=quantity of output (Real GDP)
P*Y = value of output (nominal GDP)

Begins with velocity V=PY/M
V - the number of times a unit of money enters someone’s income in a given period of time

Question 5

What does it mean that the quantity equation is an identity?

Answer 5

The quantity equation is an identity - the definitions of the four variables make it true

Question 6

What is M/P?

Answer 6

Real money balances - the purchasing power of the money sypply

I.e. M/P Expresses the quantity of money in terms of the quantity of goods and services it can buy

Question 7

What is the money demand function?

Answer 7

(M/P)^d=kY

The money demand function shows the determinants of the quantity of real money balances that people wish to hold

k - is a constant telling us how much money people want to hold for every unit of income (exogenous)

Quantity of M/P is proportional to real income

Higher income leads to greater demand for real money balances

Question 8

What is the connection between the money demand function and the quantity equation?

Answer 8

When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low)

k=1/V

Question 9

What is the quantity theory of money?

Answer 9

The assumption of constant velocity and exogenous- makes the quantity equation the quantity theory of money

MV ̅=PY

With V constant, the money supply determines nominal GDP (PY)

Real GDP is determined by the economy’s supply of K and L and the production function

The price level P= (nominal GDP)/(real GDP)

Question 10

How can we express the quantity theory in growth rates?

Answer 10

∆M/M+∆V/V=∆P/P+∆Y/Y

Important: the growth rate of a product equals the sum of the growth rates

As V is constant - ∆V/V=0

Π - inflation rate = ∆P/P
As ∆M/M+∆V/V=∆P/P
Then π = ∆M/M-∆Y/Y

Question 11

What leads to inflation?

Answer 11

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

Money growth in excess of this amount leads to inflation

Question 12

What does the quantity theory of money predict?

Answer 12

The Quantity Theory of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.

The Quantity Theory of Money assumes that the demand for real money balances depends only on real income Y.

Question 13

What is seigniorage and the inflation tax?

Answer 13

The revenue from printing money

Printing money to raise revenue is like imposing an inflation tax

Who pays for the tax? The holders of money

In countries with hyperinflation - chief source of revenue

The need to print money to finance expenditure is the primary cause of hyperinflation

Question 14

What is the Fisher effect?

Answer 14

A simple theory linking nominal interest rates and (expected) inflation

Fisher equation i=r+π

The ex ante real interest rate r is determined by equilibrium in the market for goods and services

S = I determines r

Hence, an increase in π causes an equal increase in i

Nominal interest rate moves one-for-one with changes in expected inflation - called the Fisher effect

Question 15

What is ex ante and ex post?

Answer 15

Ex ante - the real interest rate the borrower and lender expect when the loan is made i-π^e

Ex post - the real interest rate actually realized i-π

π - actual future inflation and π^e - expected

The nominal interest rate in the Fisher effect can adjust to the expected not the actual as it is not known

i=r+π^e

Question 16

What is the cost of holding money?

Answer 16

The nominal interest rate is the opportunity cost of holding money

When holding money, you give up the difference between returns on alternative assets, r, and expected real return -π^e

Cost of holding money = r-(-π^e ), which according to the Fisher equation is i (nominal interest rate)

Question 17

What does the demand for real money balances depend on?

Answer 17

The demand for real money balances depends both on income level and nominal interest rate (in quantity theory we assumed only income)

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

L denotes money demand, money is the economy’s most liquid asset

When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be.

Hence, the nominal interest rate relevant for money demand is r+ π^e

M/P=L(r+π^e,Y)

Question 18

What determines what in the money demand function?

Answer 18

For given values of r, Y, and πe, a change in M causes P to change by the same percentage

M - exogenous (determined by central bank)
r - adjusts to make S = I
Y is fixed by capital and labour
P adjusts to make M/P=L(i,Y)

Thus, the price level depends on both the current quantity of money and the quantities of money expected in the future

Question 19

How does P respond to a change in expected inflation?

Answer 19

M/P=L(r+π^e,Y)

Expected inflation increases (Fisher effect)

(M/P)^d decreases

P increases to re-establish equilibrium

Question 20

Does inflation make workers poorer?

Answer 20

Common misperception: inflation reduces real wages

This is true only in the short run, when nominal wages are fixed by contracts.

(Chap 3) In the long run, the real wage is determined by labour supply and the marginal product of labour, not the price level or inflation rate.

If inflation slows, firms will increase price of products less and thus give smaller pay raises

Question 21

What are the costs of expected inflation?

Answer 21

(1) Shoe leather cost of inflation - the costs and inconveniences of reducing money balances to avoid the inflation tax.
(2) Menu costs - firms have to change their posted prices more often
(3) The higher rate of inflation, the greater the variability in relative prices - leads to microeconomic inefficiencies in the allocation of resources when firms facing menu costs change prices infrequently
(4) Tax liabilities - tax system measures income as the nominal rather than real capital gain
(5) General inconvenience - Inflation makes it harder to compare nominal values from different time periods. This complicates long-range financial planning.

Question 22

What are the costs of unexpected inflation?

Answer 22

Arbitrarily redistributes wealth - e.g. a loan. If inflation is higher than expected, debtor wins because the debtor repays the loan with less valuable euros. When inflation is high, it’s more variable and unpredictable: πturns out different from πe more often, and the differences tend to be larger

Also hurts individuals on fixed pensions. The worker is essentially providing a loan as the pension is deferred earnings - like any creditor the worker is hurt if inflation is higher than expected

Most people are risk averse - the unpredictability hurts almost everyone

Question 23

What is a benefit of inflation?

Answer 23

Argument for moderate inflation starts with the fact that firms are reluctant to cut in workers’ nominal wages

Hence, some inflation may make labour markets work better

Sometimes increase in supply or decrease in demand leads to equilibrium real wage fall

If nominal wages cannot be cut - let inflation do the job

Without inflation - wage stuck at equilibrium - increase in unemployment