Inflation and the Quantity Theory of Money

Question 1

Give a definition of Inflation

Answer 1

Inflation is an increase in the average level of prices.

Question 2

Inflation can be measures using several different price indexes. These price indexes are based on different bundles of goods. Name 3 and explain them.

Answer 2

1. Consumer price index: Measures the average price for a basket of goods and services bought by a typical American consumer.
2. GDP deflator: The ratio of nominal to real GDP multiplied by 100. The GDP deflator covers all final goods
3. Producer price index: Measure the average price received by producers. Measures the prices of intermediate as well as final goods. PPI exists for different industries and are often used to calculate changes in the cost of inputs.

Question 3

What’s a ‘real price’?

Answer 3

A real price is a price that has been corrected for inflation.

Question 4

What’s the use of ‘real prices’?

Answer 4

Used to compare the prices of goods over time.

Question 5

Explain the Quantity Theory of Money

Answer 5

The quantity theory of money does two things:

First, it sets out the general relationship between money, velocity, real output, and prices.

Second, it helps to explain the critical role of money supply in determining the inflation rate.

Question 6

Write down the equation for the Quantity Theory of Money, and explain each variable

Answer 6

M x v = P x Yr

M: The money you are paid

v: Velocity of money, the average number of times a dollar is spent on final goods and services in a year.

P: Prices

Yr: A measure of the real goods and services that you buy.

Question 7

What’s disinflation?

Answer 7

A reduction in the inflation rate

Question 8

What can cause deflation?

Answer 8

Caused by a decrease in the velocity of money, which can be triggered by a crisis. In a crisis households try to save more, and thus spend less.

Question 9

According to the Quantity Theory of money: In the long run,…

Answer 9

..money is neutral.

Question 10

Explain money illusion

Answer 10

Money illusion is when people mistake changes in nominal prices for changes in real prices.

Question 11

Why does inflation redistribute wealth among the public?

Answer 11

Suppose that a lender lends money at an interest rate of 10%, but that over the course of the year the inflation rate is also 10%. The lender is paid 10% interest, but they are paid in dollars that have become 10% less valuable.

Thus, the lender’s real rate of return is 0%.

Thus, inflation can reduce the real return that lenders receive on their loans, in effect transferring wealth from lenders to borrowers.

Question 12

How is the real interest rate calculated?

Answer 12

Real interest rate = Nominal rate - Inflation rate

Question 13

What’s the fisher effect?

Answer 13

The fisher effect is the tendency of nominal interest rates to increase with expected inflation rates.

Question 14

Write down the fisher effect equation

Answer 14

Nominal interest rate = Expected inflation rate + Equilibrium real rate of return

Question 15

Explain monetizing the debt by governments

Answer 15

Monetizing the debt is when the government pays off its debts by printing money.

Question 16

Why doesn’t the government always just inflate it’s debt away?

Answer 16

One reason is the Fisher effect: If lenders expect that the government will inflate its debt away, they will only lend at high nominal rates of interest.

Another reason is that people who buy government bonds are typically voters who would be upset if their real returns were shrunk to zero or less

Question 17

Explain how inflation can interact with other taxes

Answer 17

For example, you buy a share of stock for $100, and over several years inflation alone pushed its price to 150$. The U.S. tax system requires that you pay profits on the 50$ gain even though the gain is illusory. In real terms, the stock hasn’t increased in price at all yet you must still pay tax on the phantom gain.

In this case, inflation leads to people paying capital gain taxes when they should not. The overall tax burden rises. The long run effect is to discourage investment in the first place.

Question 18

Why is inflation painful to stop?

Answer 18

The government can reduce inflation by reducing the growth in the money supply.

But this has an effect on the economy:
When workers, firms, and consumers expect 10% inflation, a lower rate is a shock.

At first, firms may reduce output and employment. Furthermore, contracts signed on the expectation of 10% inflation are now out of whack with actual inflation.