Inflation and Deflation Flashcards
Definition of Deflation:
- Sustained period of negative inflation
Definition of Hyperinflation:
- inflation of more than 50 percent per month (or roughly 13,000 percent per year)
Definition of Velocity of money: (formula)
- Shows how quickly money moves through the economy
- Ratio of nominal GDP to the money supply:
( V = P . Y/ M )
- “V” stand for Velocity of money
- “P” stand for Price
- “Y” stand for Output
- “M” stand for Money Supply
Definition Quantity equation of money: (Formula)
- relationship among the money supply, velocity, and nominal GDP:
M.V = P.Y
- “V” stand for Velocity of money
- “P” stand for Price
- “Y” stand for Output
- “M” stand for Money Supply
In the long run, two of the growth rates in the Quantity Equation of Money are outside the control of the central bank:
- Output
- Velocity
Why the Output growth in the long-run is independent from central bank?
- Output growth depends on factors that affect the economy’s productivity, such as new technologies.
- Long-run neutrality means that monetary policy is irrelevant, therefore, the central bank.
Why the Velocity growth in the long-run is independent from central bank?
- Long-run changes in velocity are driven primarily by changes in transaction technologies—the methods people use to acquire and spend money.
- Velocity moves in the opposite direction from money demand.
- Innovations such as ATMs have slowly reduced money demand, so velocity has risen.
From Money Growth to Inflation (Graph)
- “i” stand for nominal interest rate
- “r” stand for real rate
- “AE” stand for aggregate expenditure
- “Y” stand for output
- “π” stand for inflation rate
Determinants of Money Growth and Inflation (graph)
what is Bimetallism?
- Monetary system in which money is backed by both gold and silver
what is The Output–Inflation Trade-Off ?
- A central bank allows inflation to rise if it accommodates an adverse supply shock, such as a rise in oil prices.
- The aim of policymakers is not to raise output but merely to keep it from falling below potential.
- Then if the central bank want to return to the prevous equilibrium, it use desinflation policies
- desinflation policies created a temporally fall in output
what is the definition “Printing money” for the central bank to the government?
- Financing government budget deficits by selling bonds to the central bank
Definiton of “Seigniorage revenue”:
- Revenue the government receives from printing money
what is the inflation fallacy ?
- a worker’s standard of living depends on her real wage (not nominal wage), the ratio of her/his wage to the aggregate price level.
- Inflation raises the numerator and denominator of this ratio by the same amount, so the real wage is unchanged.
- The real wage is determined by other factors, such as the worker’s productivity.
which are the adverse effects of high inflation that economists have identified?
- shoe leather costs
- distracted firms
- relative-price variability
- income inequality
Definition of Shoe leather costs:
- Inconveniences that result from holding less money when inflation is high.
- Lower money holdings mean that transactions become harder, making life less convenient.
- People try to minimize their money holdings so, they rush to buy goods as soon as they receive their pay to avoid the fast depreciation of it whealth.
How “Distracted Firms” is one of the adverse effects of high inflation?
- firms try to minimize money holdings; they constantly move cash into bank accounts with interest that compensates for inflation.
- These activities consume managers’ time and attention. Coping with inflation leaves less time for normal business activities, such as developing new products or improving productivity
what is “Relative-Price Variability” in an economy with high inflation?
- When inflation is high, all firms raise their prices by large amounts. But they do so at different times.
- Some prices are abnormally high compared to others, just because they have adjusted more recently. In other words, inflation causes dispersion in relative prices.
How income inequality get worse with high inflation?
- The poor have relatively large money holdings. They receive their wages in cash and have no bank accounts, so inflation is costly.
- The rich have access to bank accounts with high nominal interest rates that compensate for inflation.
- The salaries of professional workers are often indexed to inflation
- The wages of unskilled workers are slower to adjust when inflation accelerates.
why moderate inflation is stil harmful? (acording to some economist) (most important)
- Inflation Uncertainty
- Inflation and Taxes
why Inflation Uncertainty is bad? (acording to some economist)
- Uncertainty about inflation creates risk in loan markets
- Wealth is redistributed between borrowers and lenders. This redistribution can harm the economy
- uncertainty about inflation discourages both borrowers and lenders from entering the loan market. Each group is deterred by the risk of redistributions.
- The financial system becomes less effective at channeling funds to investors from savers, hurting economic growth.
why Inflation have an adverse effect in the tax proccess? (and secondary effect)
- When inflation rises, people pay higher taxes on the income they earn from savings.
- You pay taxes based on your nominal interest income. This income has risen, so you pay higher taxes on the same real income.
- When inflation raises these taxes, saving falls. The result is lower investment and lower economic growth.
Definition of “After-tax real interest rate” (R¬):(formula)
- the interest rate adjusted for both taxes and inflation:
R¬ = (1 - m) r - m.pi
- “r” stand for real interest rate
- “pi” stand for inflation
- “m” stand for tax rate
- “R” stand for “After-tax real interest rate”
Definition of “Liquidity trap”:
- situation in which output is below potential at a nominal interest rate of zero (a real interest rate of -pi)
- Eliminating the central bank’s usual ability to raise output and inflation
- Zero-bound problem
Definition Zero bound:
- The limit on the nominal interest rate; a central bank cannot reduce “i” below zero, which limits its ability to stimulate the economy
A Liquidity Trap (graph)
A Vicious Circle graph (liquidity trap)
The Market for Money in a Liquidity Trap (graph)
Proccess of a liquidity trap (steps)
- Lower Bounds on Interest Rates
- Role of Deflation
- The Irrelevance of Money Growth
what is the behabiour of the “Lower Bounds on Interest Rates”
- There is a limit on the central bank’s options: it must set a nominal rate of zero or higher.
- A negative nominal interest rate is impossible.
- problem can arise if an adverse expenditure shock occurs, causing a recession.
- To end the recession, the central bank must reduce the real interest rate, and the lower bound may get in the way. (because the interest rate is already zero).
what is the Role of the Deflation in a liquidity trap?
- If an economy enters a liquidity trap, it can be hard to escape. Indeed, the economy can fall into a vicious circle in which the liquidity trap and deflation reinforce one another.
- In a liquidity trap, a high real interest rate keeps the economy in a recession.
- The recession reduces inflation through the Phillips curve; even if inflation is positive initially, it may fall below zero.
- With the nominal interest rate stuck at zero and inflation falling, the real interest rate rises.
- The higher real interest rate worsens the recession, which pushes inflation down further, and so on.
- Output and inflation can spiral downward.
Is there a escape from a liquidity trap ?
According to some economist:
- Reducing Long-Term InterestRates
- Raising Expected Inflation
- Using Fiscal Policy
How do you escape a liquidity trap by reducing Long-Term Interest Rates?
- The central bank can reduce long-term rates by reducing either expected short rates or term premiums
the expectations theory of the term structure of interest rates (graph)(formula)
How the Fed escape (at least tried) the liquidity trap by reducing Long-Term Interest Rates? (2008-2010)(expected interest rates)
the Federal Reserve tried to do both:
- Influence expected interest rates:
* The Fed sought to influence expected interest rates through announcements.
- During 2009 and 2010, as the Federal Open Market Committee maintained a target range of 0 to 0.25 percent for the federal funds rate, it repeatedly signaled an intention to keep its target low.
- A typical announcement occurred on August 10, 2010, when the FOMC said that economic conditions “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”
- The “extended period” language was meant to drive down expected future interest rates in the equation for long-term rates.
How the Fed escape (at least tried) the liquidity trap by reducing Long-Term Interest Rates? (2008-2010)(term premiums)
the Federal Reserve tried to do both:
- Influence the term premiums:
* by shifting the composition of its open-market operations
* it increased its purchases of long-term bonds and bought relatively few short-term bonds
* By raising the demand for long-term bonds, the Fed hoped to raise their prices relative to those of short-term bonds and thereby reduce their yields to maturity
* It reduces long-term interest rates for a given path of short-term rates; in other words, it reduces term premiums.
How do you escape a liquidity trap by Raising Expected Inflation?
- central bank facing a liquidity trap should announce that it plans to increase inflation in the future.
- If the public believes that the central bank eventually will raise inflation, then expected inflation rises.
- The efficacy of this tactic is unclear, partly because the Federal Reserve has not tried it.
How do you escape a liquidity trap by Using Fiscal Policy?
- By using expansionary fiscal policy:
* An increase in government spending or a tax cut shifts out the AE curve, raising output at the current real interest rate
* If an inward shift of the curve has produced a liquidity trap, a fiscal expansion can reverse this shift.
* In addition, if deflation is occurring, fiscal policy can cause an output boom that pushes inflation above zero.
* A disadvantage of fiscal expansion is that it increases the level of government debt.
* Keynes, who pointed out the problem of the liquidity trap, also suggested this.
