Inflation Flashcards
Explain what base money is.
Base money is coins, bank notes, and deposits of commercial banks at the central bank.
Explain what fiat money is.
Fiat money are objects that are intrinsically worthless but are commonly accepted for payments (like dollar bills).
Explain what the quantity equation says and why it always holds.
Mt × Vt = Yt × Pt, that is, money times velocity has to equal real GDP times the price level. The quantity equation must hold because the money that is around must be used to buy the GPD. If each dollar is used V times, then M × V is the total value of transactions, which must equal the total value purchased.
Suppose GDP per capita growth is 2% and velocity growth is 1%. If the central bank has an inflation target of 2%, by how much must base money grow?
gM +gV =gy +π =⇒ gM =gy +π−gv =2%+2%−1%=3%
Explain what is meant by the Classical Dichotomy.
In the long run, all prices adjust and the real side and the nominal side of the economy are separate. As a result, real variables are unaffected by nominal variables (“money is neutral”).
What does the Fischer equation say? Provide intuition for it.
Ex ante: nominal interest rate equal real interest rate plus expected infla- tion rate; es post: nominal interest rate equal real interest rate plus realized inflation rate. As is generally true, the change of a nominal variable is the change of the real component plus the change in prices (“inflation”). The real component here is the real interest rate.
Suppose that banks offer fixed–rate mortgages at around 3.5%. Suppose that the average real interest is around 2%. What must inflation expectations be?
3.5% − 2% = 1.5%.
Explain why the present value of a future payment decreases if the interest rate in- creases.
Because a higher interest rate implies that future payments are discounted more heav- ily.
Explain why the present value of a future payment decreases if the payment is made at a later future date.
Because a later payment gets discounted more heavily because there are more periods between today and the later payment during which interest is paid.
Name three costs that high inflation imposes on an economy.
shoe leather costs; menu costs; redistribution costs.
Explain how a budget deficit can lead to inflation.
A budget deficit has to be financed either through issuing new bonds or through printing money. If the government does the latter excessively, then inflation results.
What did Milton Friedman mean when he famously remarked that “Inflation is always and everywhere a monetary phenomenon”?
He meant that when you see high inflation, then there must have been high money growth rates. This follows from the quantity equation.
What did Tom Sargent mean when he famously remarked that “Persistent Inflation is always and everywhere a fiscal phenomenon”?
He meant that when you see high money growth rate (that lead to high inflation), then there must have been high government deficits. This follows from the government budget constraint.
