Econ 282: Chapter 5 Inflation

Question 1

The quantity theory of money

Answer 1

-A simple theory linking the inflation rate to the growth rate of the money supply
-Begins with the concept of velocity

Question 2

Velocity

Answer 2

Basic concept: the rate at which money circulates
Definition: the number of times the average dollar bill changes hands in a given period of time

Question 3

Velocity equation

Answer 3

V=T/M
where V is velocity
T is value of all transactions
M is money supply
-Use nominal GDP as a proxy for total transactions
V=PxY/M
P is price of output (GDP deflator)
Y is quantity of output (real GDP)
PxY is value of output (Nominal GDP)

Question 4

The quantity equation

Answer 4

MxV = PxY
-follows from the preceding definition of velocity
-it is an identity: it holds by definition of the variables

Question 5

Money demand and Quantity Equation

Answer 5

M/P = real money balances, the purchasing power of the money supply
A simple money demand function (M/P)d = kY
k = how much people wish to hold for each dollar of income
k is exogenous
-Connection between money demand and quantity equation: k=1/V

Question 6

How price level is determined

Answer 6

MxVbar = PxY
-With V constant, the money supply determines nominal GDP = (PxY)
-Real GDP is determined by the economy’s supplies of K and L and the production function
-The price level is P = (nominal GDP)/(real GDP)

Question 7

Pi

Answer 7

denotes the inflation rate
-(Change in pi)/(pi)
To solve for pi: (change in M)/(M) - (change in Y)/(Y)

Question 8

The quantity theory of money

Answer 8

predicts a one-for-one relationship between changes in the money growth rate and changes in the inflation rate
Implies…
-Countries with higher money growth rates should have higher inflation rates
-The long run trend in a country inflation rate should be similar to the long run trend in the country money growth rate

Question 9

Inflation and interest rates

Answer 9

-nominal interest rate, I, not adjusted for inflation
-Real interest rate, r adjusted for inflation
R=I-pi

Question 10

The Fisher Effect

Answer 10

Equation: I=r+pi
S=I determines r
-an increase in pi causes an equal increase in I
-this one for one relationship is called the fisher effect

Question 11

E-pi

Answer 11

Expected inflation rate

Question 12

Ex ante real interest rate

Answer 12

I-Epi=the real interest rate people expect at the time they buy a bond or take out a loan

Question 13

Ex post real interest rate

Answer 13

I-pi=the real interest rate actually realized

Question 14

Money demand and the nominal interest rate
-in the quantity theory of money, the demand for real money balances depends only on real income

Answer 14

-another determinant of money demand: the nominal interest rate i
-THE OPPORTUNITY cost of holding money
-money demand depends negatively on I.

Question 15

The money demand function

Answer 15

(M/P)d=L(I,Y)
-depends negatively on I, positively on Y
Higher Y increases spending on GandS so increases need for money
I is the opportunity cost of holding money

Question 16

The second money demand function

Answer 16

(M/P)d=L(I,Y)
=L(r+Epi,Y)
-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+Epi

Question 17

How P responds to change in Epi

Answer 17

M/P=L(r+Epi, Y)
-Increase in Epi means an increase in i (fisher effect)
-therefore, decrease in (M/P)d
-therefore increase in P to make (M/P) fall
Explained: if you think prices are going to go up, you might spend (investment) now . You spend everything but there are still the same quantity in the market. The government adjusts by increasing the prices a bit, so you can buy less. The government increased prices to keep things fair since everyone is buying a lot (because inflation is low and prices are lower). Spending a lot makes prices go up a bit