Lecture 14 - Money Market and Inflation in the Long Run Flashcards
What is the equilibrium in the money market? How are all the variables determined?
- supply of real money balances = M/P
- real money demand = L(r + (π subscript e), Y)
- equilibrium when supply = demand
- M: exogenous, r: adjusts to make S = I, Y = F(K,L), P: endogenous, adjusts to bring M/P = L(i,Y)
In an ideal run, over the long-run, across large populations, what would the relationship between (π subscript e) and π be?
- π subscript e = π
- expected inflation = actual inflation
Why in the short-medium run does the inflation rate not equal the expected inflation rate?
- misinformation
- may change when people get new information (e.g. about prices)
- pessimism/optimism
- inattention
For given values r, Y and M, how does P respond to changes in (π subscript e)?
increase in (π subscript e) –> i increases (Fisher effect) –> demand for real money decreases –> P increases
For given values of r, Y and (π subscript e), what does a change in M cause P to do?
- Channel 1:
- a change in M causes P to change by the same percentage just like in the Quantity Theory of Money
- Channel 2:
- by QT/Fisher effect, M ↑ means (π subscript e) ↑, and i ↑, and P ↑
- overall effect, P ↑↑
- price level today depends on both current and future monetary policy (through inflation expectations)
Show the cyclical nature of money, prices and interest rates?
- money supply and money demand determine prices
- prices determine the inflation rate
- the inflation rate determines the nominal interest rate (through the Fisher effect)
- the nominal interest rate affects the money supply and demand
What is the classical view of inflation?
a change in the price level is merely a change in the units of measurement, in other words, changes in inflation have no real effects
What are the 2 categories for the social costs of inflation?
- costs when inflation in expected
- additional costs when inflation is different than people had expected
Define shoe-leather costs
the costs and inconveniences of reducing money balances to avoid the inflation tax
The quantity theory of money assumes constant velocity, why may this mean that the quantitative theory is not suitable for the short-run?
- high inflation leads to high shoe leather costs, leads to less demand for money, which leads to higher velocity
- velocity may vary in the short run
- meant to be constant, quantity theory not suitable for the short run
Define menu costs, give an example
- the costs of changing prices
- cost of printing new menus
What is the relationship between inflation and menu costs?
the higher the inflation, the more frequently firms must change their prices and incur these costs
Explain how menu costs can lead to relative price distortions, and thus be a cost of expected inflation
- firms facing menu costs change prices infrequently
- example: suppose a firm issues new catalogue each January. As the general price level rises throughout the year, the firm’s relative price will fall
- different firms change their prices at different times, leading to relative price distortions
- which cause microeconomic inefficiencies in the allocation of resources
Explain how unfair tax treatment may be a cost of expected inflation
- some taxes are not adjusted to account for inflation, such as the capital gains tax
- for example:
- Jan 1: you bought £10,000 worth of a stock
- Dec 31: you sold the stock for £11,000, so your nominal capital gain was £1000 (10%).
- Suppose π = 10% during the year. Your real capital gain is £0.
- But the govt requires you to pay taxes on your
£1000 nominal gain!
Explain how inflation may complicate long-range financial planning
- inflation makes it harder to compare nominal values from different time periods
- this complicates long-range financial
planning
