Chapter 5 - inflation: its causes, effects, and social costs Flashcards
recall ch2, what is inflation
inflation is %change in GDP deflator over period
inflation (current period) = (deflator current - old)/old
What is the QTM? What does it explain? what does it link?
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
What is the QTM rewritten Md function
MV = PY
Define velocity, what is the equation? What is the assumption
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
Over time in Canada, what has driven the increase in V
increased ease of payment
EX. credit/debit cards, apple pay, transfers, etc.
What is the formula for the purchasing power of the stock of money?
purchasing power = M/P
expresses Q of money in terms of Q of G&S it can buy
what is the Money demand function?
(M/P)^d = k*Y
k - fraction held for each dollar of income (exogenous)
What is the money quantity equation?
MV=PY
or
M/P = (1/V)*Y
What is the connection between money demand and quantity equations?
what happens when people hold more/less of their income
k = 1/V
hold more -> k high -> V falls
hold less -> k low -> V rises
In deriving the QTM, what are assumptions and how does impact the money quantity equation?
V constant/exogenous (V = Vbar)
Y fixed (represents income and output)
money equation:
MVbar = PY
M determines P
In the QTM, how is price level determined?
P = nominal GDP / real GDP
how does Money supply determine nominla GDP
since V constant, M impacts P*Y (aka GDP)
what is the Quantity equation in growth rates?
what do the variables represent
changeM/M = changeP/P + changeY/Y
ChangeP/P = inflation (pi)
inflation = ChangeM/M - changeY/Y
aka pi = growth rate money supply - growth rate output
Inflation definition wrt growth rates
inflation: excess growth from the amount money supply needs for economic growth
inflation = Ms growth rate - Y growth rate
what does QTM predict:
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)
in the LR, what is inflation equal to
LR: inflation = growth of money supply
since Y is given and fixed in LR
What are QTM implications on countries
countries with higher Ms growth should have higher inflation
LR trend in country’s inflation rate similar to LR trend in Ms growth
What is nominal interest rate? What is real interest rate?
nominal interest: paid by the bank
i = r + inflation
real interest: increase in purchasing power
r = i - inflation
What is the fisher effect? and fisher equation?
the 1-1 relationship b/w inflation rate and nominal interest rate
equation:
i = r + pi (pi=inflation)
using fisher effect, if money supply increases 1% in the LR, inflation will rise by what %?
i = r + pi
i = 0% + 1%
1% = 1% (one for one relation)
to prevent inflation, what does the central bank do
central bank reduces M growth rate to prevent inflation rising
inflation = Mgrowth - Y growth
What is ex ante and ex post
How does this impact the Fisher effect?
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)
QTM states that demand for real money balances depends on only ?
real income (Y),
direct relationship b/w M and Y
What are the two determinants of money demand. What are the relationships with demand for money.
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
What is the Money demand function
(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
What is the Equillibrium for Money market balances
M/P = L(r+E*Pi, Y) = (M/P)^d
How are the following variables determined in the LR:
M, r, Y, P
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)
How does P respond to changeM
changes in M causes P to change by the same percentage (QTM)
How does expected inflation vary over SR to LR
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)
How P responds to change E*pi
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
What is the LR disadvantages of inflation
currency becomes undesirable (pp falls), basket of G&S becomes increasingly more expensive
reduces savings -> increases public debt
T or F: inflation reduces real wages
True: in SR (nominal wage fixed by contracts)
False: real wage determined by labor supply and MPL (not P or pi)
List the costs of expected inflation (5)
Shoeleather cost
menu cost
relative price distortions
unfair tax treatment
general inconvenience
What are shoeleather costs?
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)
What are menu costs
cost of expected inflation
menu costs: cost of changing prices
what are Relative price distortions
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)
What is unfair tax treatment? Give an example
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
What are general incnvenience?
cost of expected inflation
- makes harder to compare nominal values from different time periods
- complicated Long-range financial planning households (needs adjust)
list the 2 additional cost of unexpected inflation
Arbitrary redistribution of purchasing power
Increased uncertainty
what is Arbitrary redistribution of purchasing power? Who does it affect?
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
What is increased uncertainty and its result?
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
What is the Benefit of inflation, in what market?
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
What is hyperinflation criteria?
What is impact on costs?
What happens to money function?
Caused by?
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)
Why would gov print money (if it causes inflation)?
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)
What is seignorage:
Seignorage: revenue raised from printing money
inflation tax: printing money to raise revenue causes inflation (inflation is tax on those who hold money)
What is a theoretical solution to hyperinflation?
stop printing money
requires drastic and painful restraint
What is the Classical Dichotomy?
What does it imply?
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)
Define real variables and list 4.
Real variables: measured in physical units/quantities/relative prices
- Y (output)
- real wage (output earned per hour)
- r (real interest rate): output earned in future by lending out one unit today
- Employment & Unemployment
Define Nominal variables and list 4
Nominal variables: measured in dollars
- Nominal wage: dollars per hour work
- Nominal interest rate (i): dollars earned in future by lending one dollar today
- Price level (P): amount $ to buy basket
- Money supply (Ms)
What is the Neutrality of money
changes in Ms no affect on real variables in LR
TF: monetary policy can not effect:
- output, employment, r, real wage
Given the neutrality of money, what happens in SR vs LR if fiscal policy changes?
Bank cannot change Ms to impact Y or U/L
SR: policy may impact
LRL only bring inflation
What is defining LR and SR on a macro level
SR: prices all fixed (inputs and outputs)
LR: prices all flexible
What is defining LR and SR on a micro level
SR: business can change min 1 input
LR: assume no fixed variables (all change)
in classical dichotomy, what determines the price level of all nominal variables
money market EQM
