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ECON 2H03 > Chapter 5 - inflation: its causes, effects, and social costs > Flashcards

Chapter 5 - inflation: its causes, effects, and social costs Flashcards

1
Q

recall ch2, what is inflation

A

inflation is %change in GDP deflator over period
inflation (current period) = (deflator current - old)/old

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2
Q

What is the QTM? What does it explain? what does it link?

A

how Q of money relates to economic variables (Price and income)

explains how money affects the economy in the long run

links inflation rate to growth rate of Ms

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3
Q

What is the QTM rewritten Md function

A

MV = PY

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4
Q

Define velocity, what is the equation? What is the assumption

A

velocity: number of times the average dollar bill changes hands in given period
assumption: velocity fixed and set by institutions

V = T/M (value transaactions/ms)
V = PY / M (aka PriceQuantity)/ms

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5
Q

Over time in Canada, what has driven the increase in V

A

increased ease of payment

EX. credit/debit cards, apple pay, transfers, etc.

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6
Q

What is the formula for the purchasing power of the stock of money?

A

purchasing power = M/P

expresses Q of money in terms of Q of G&S it can buy

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7
Q

what is the Money demand function?

A

(M/P)^d = k*Y

k - fraction held for each dollar of income (exogenous)

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8
Q

What is the money quantity equation?

A

MV=PY
or
M/P = (1/V)*Y

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9
Q

What is the connection between money demand and quantity equations?

what happens when people hold more/less of their income

A

k = 1/V

hold more -> k high -> V falls
hold less -> k low -> V rises

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10
Q

In deriving the QTM, what are assumptions and how does impact the money quantity equation?

A

V constant/exogenous (V = Vbar)
Y fixed (represents income and output)

money equation:
MVbar = PY

M determines P

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11
Q

In the QTM, how is price level determined?

A

P = nominal GDP / real GDP

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12
Q

how does Money supply determine nominla GDP

A

since V constant, M impacts P*Y (aka GDP)

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13
Q

what is the Quantity equation in growth rates?
what do the variables represent

A

changeM/M = changeP/P + changeY/Y

ChangeP/P = inflation (pi)
inflation = ChangeM/M - changeY/Y
aka pi = growth rate money supply - growth rate output

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14
Q

Inflation definition wrt growth rates

A

inflation: excess growth from the amount money supply needs for economic growth

inflation = Ms growth rate - Y growth rate

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15
Q

what does QTM predict:

A

1-for-1 relation b/w changes in Ms growth and inflation rate
since changY/Y depends on production factors and tech (all fixed for now)

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16
Q

in the LR, what is inflation equal to

A

LR: inflation = growth of money supply
since Y is given and fixed in LR

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17
Q

What are QTM implications on countries

A

countries with higher Ms growth should have higher inflation
LR trend in country’s inflation rate similar to LR trend in Ms growth

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18
Q

What is nominal interest rate? What is real interest rate?

A

nominal interest: paid by the bank
i = r + inflation
real interest: increase in purchasing power
r = i - inflation

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19
Q

What is the fisher effect? and fisher equation?

A

the 1-1 relationship b/w inflation rate and nominal interest rate

equation:
i = r + pi (pi=inflation)

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20
Q

using fisher effect, if money supply increases 1% in the LR, inflation will rise by what %?

A

i = r + pi
i = 0% + 1%
1% = 1% (one for one relation)

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21
Q

to prevent inflation, what does the central bank do

A

central bank reduces M growth rate to prevent inflation rising

inflation = Mgrowth - Y growth

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22
Q

What is ex ante and ex post

How does this impact the Fisher effect?

A

Ex-ante: real interest rate that borrower and lender expect when loan is made
aka expected real interest rate

Ex-post: real interest rate that is realized (actual)

New fisher effect:
i = r + pi*e (ex ante)

23
Q

QTM states that demand for real money balances depends on only ?

A

real income (Y),

direct relationship b/w M and Y

24
Q

What are the two determinants of money demand. What are the relationships with demand for money.

A

real income, Y (from QTM)
- (+) relationship: high Y -> spend rise -> Md rise
nominal interest rate, i (opp cost holding)
- (-) relationship: high rate -> people rather invest -> Md falls

25
Q

What is the Money demand function

A

(M/P)^d = L(i, Y) (relations: i -, Y +)
L - used for Md because money is liquid asset

OR

(M/P)^d = L(r+Epi, Y)
r + Epi - nominal interest rate

26
Q

What is the Equillibrium for Money market balances

A

M/P = L(r+E*Pi, Y) = (M/P)^d

27
Q

How are the following variables determined in the LR:
M, r, Y, P

A

M - exogenous (central bank)
r - adjusts to ensure S=I (ch3)
Y - Ybar = F(kbar, Lbar) (ch2)
P - adjusts to ensure M/P = L(i,Y)

28
Q

How does P respond to changeM

A

changes in M causes P to change by the same percentage (QTM)

29
Q

How does expected inflation vary over SR to LR

A

SR: Epi may change when obtain new info
- EX. central bank announce raise M next year, people expect higher prices tf Epi change (before anything even happens)
LR: people do not consistently over/under forecast inflation E*pi = pi (on average)

30
Q

How P responds to change E*pi

A

changes in expected inflation change the nominal interest rate and money demand and thus P (to adjust back to establish EQ)

EX. Rise in E*pi (expected inflation) causes:
1. Rise i (the fisher effect)
2. Real money demand Fall aka. (M/P)d
3. Rise P (to make M/P fall to re-establish EQ

31
Q

What is the LR disadvantages of inflation

A

currency becomes undesirable (pp falls), basket of G&S becomes increasingly more expensive
reduces savings -> increases public debt

32
Q

T or F: inflation reduces real wages

A

True: in SR (nominal wage fixed by contracts)
False: real wage determined by labor supply and MPL (not P or pi)

33
Q

List the costs of expected inflation (5)

A

Shoeleather cost
menu cost
relative price distortions
unfair tax treatment
general inconvenience

34
Q

What are shoeleather costs?

A

cost of expected inflation
costs of reducing money balances to avoid inflation tax

if pi rise -> i rise -> Md falls

Result: same monthly spending, lower holdings, more frequent/smaller cash withdrawals from bank

(need more money to buy same amount of G&S, more frequent/smaller withdrawals)

35
Q

What are menu costs

A

cost of expected inflation
menu costs: cost of changing prices

36
Q

what are Relative price distortions

A

cost of expected inflation
relative price distortions: microeconomic inefficiencies in the allocation of resources due to firms facing menu costs change prices infrequently (not at the same time)

37
Q

What is unfair tax treatment? Give an example

A

cost of expected inflation
Unfair tax treatment: some tax not adjusted for inflation

EX. Capital gains tax:
buy 10$ stock sell for 11$, nominal gain is 1$.
if inflation is 10%, real capital gain is 0$
YET, you pay taxes on the 1$ nominal gain

38
Q

What are general incnvenience?

A

cost of expected inflation
- makes harder to compare nominal values from different time periods
- complicated Long-range financial planning households (needs adjust)

39
Q

list the 2 additional cost of unexpected inflation

A

Arbitrary redistribution of purchasing power
Increased uncertainty

40
Q

what is Arbitrary redistribution of purchasing power? Who does it affect?

A

cost of unexpected inflation
when pi DNE pi*E causes a redistribution of wealth within economic groups (gain at the other’s expense)

Who impacted:
- Financial markets: lender/borrower
- Labor markets: employee and employer

if pi > EPi : pp transferred to borrowers
if pi < Epi: pp transferred to lenders

41
Q

What is increased uncertainty and its result?

A

cost of unexpected inflation
- inflation becomes more variable/unpredictable when high

  • Arbitrary distribution more likely due to larger differences in pi and pi*E

result: increased uncertainty, making risk-adverse people worse off

42
Q

What is the Benefit of inflation, in what market?

A

Benefit of inflation is in Labor market

when nominal wages reduce -> allows real wages to reach EQM levels without making nominal wage cuts
TF: moderate inflation improves functioning of labor markets

43
Q

What is hyperinflation criteria?
What is impact on costs?
What happens to money function?
Caused by?

A

criteria: when pi >= 50% per month
costs: go from moderate to HUGE

money: cease function ‘store of value’ and may not serve other (unit account, medium exchange)

Cause: excessive Ms growth
- printing money (if rapid enough)

44
Q

Why would gov print money (if it causes inflation)?

A

to get out of continual and growing gov deficit
first option: finance through taxes
second option: borrow from lenders (credibility)
third option: print money (central bank)

45
Q

What is seignorage:

A

Seignorage: revenue raised from printing money
inflation tax: printing money to raise revenue causes inflation (inflation is tax on those who hold money)

46
Q

What is a theoretical solution to hyperinflation?

A

stop printing money

requires drastic and painful restraint

47
Q

What is the Classical Dichotomy?
What does it imply?

A

the theoretical seperation of real and nominal variables in the classical model

Implies:
Nominal variables no effect on real variables
(dollar variables don’t impact Q variables)

48
Q

Define real variables and list 4.

A

Real variables: measured in physical units/quantities/relative prices

  1. Y (output)
  2. real wage (output earned per hour)
  3. r (real interest rate): output earned in future by lending out one unit today
  4. Employment & Unemployment
49
Q

Define Nominal variables and list 4

A

Nominal variables: measured in dollars

  1. Nominal wage: dollars per hour work
  2. Nominal interest rate (i): dollars earned in future by lending one dollar today
  3. Price level (P): amount $ to buy basket
  4. Money supply (Ms)
50
Q

What is the Neutrality of money

A

changes in Ms no affect on real variables in LR

TF: monetary policy can not effect:
- output, employment, r, real wage

51
Q

Given the neutrality of money, what happens in SR vs LR if fiscal policy changes?

A

Bank cannot change Ms to impact Y or U/L
SR: policy may impact
LRL only bring inflation

52
Q

What is defining LR and SR on a macro level

A

SR: prices all fixed (inputs and outputs)
LR: prices all flexible

53
Q

What is defining LR and SR on a micro level

A

SR: business can change min 1 input
LR: assume no fixed variables (all change)

54
Q

in classical dichotomy, what determines the price level of all nominal variables

A

money market EQM

ECON 2H03 (8 decks)

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