Lecture 3 Flashcards
Define inflation
the loss of the value of money
Why does inflation occur?
because the supply of money increases faster than the supply of the goods
Why can the supply of money can increase?
- because private (bank) money increases rapidly as banks increase the supply of credit
- government money increases as the government increases the supply of fiat money, normally to buy goods and services without rising taxes
Define fiat money
Fiat money is a government-issued currency that is not backed by a commodity such as gold.
What is the inflation rate?
the percentage change in the price level
What is the equation for the inflation and what do each of the components mean?
Πt = [P(t+1) - P(t)]/Pt
where
Πt is the inflation rate
P(t+1) is the price level in the next period
P(t) is the price level in this period
What can we use as a measure of the price level in the equation for inflation rate? What does this mean for the equation for inflation rate?
CPI
this means that the equation for inflation rate can be
Πt = [(new CPI-initial CPI)/initial CPI] x 100
What is the inflation rate target?
1-3%
According to the Phillip’s curve, there is an inverse relationship between inflation rate and what? What does this mean?
unemployment
this means that an increase in the inflation rate leads to a decrease in unemployment
Will the CPI tend to overstate or understate the cost of living?
overstate
Why does the CPI tend to overstate the cost of living?
due to substitution bias, new goods and quality changes
The CPI can overstate the cost of living due to substitution bias. What is this?
This is when consumers substitute towards goods that are relatively inexpensive when the prices change
The CPI can overstate the cost of living due to the introduction of new goods. What does this mean?
the variety increases the standard of living, but new goods are not included in the basket right away
The CPI can overstate the cost of living due to quality changes. What does this mean?
as the quality of a good rises, it’s value rises even if the dollar price remains the same
In NZ, whose job is it to control the inflation rate?
the reserve bank
What is disinflation?
a slowing of the rate of inflation
Low inflation typically reflects the expansion of what?
private (bank) money
How do central banks influence the expansion of private money?
by setting interest rates and raising them when inflation gets too high
What does the central bank hope to do by increasing interest rates?
they are hoping to slow down the private creation of credit
Why does high inflation occur?
because of an expansion of the government money supply
What is the equation for the expected inflation
Πet = [Pe(t+1) - P(t)]/Pt
where
Πt is the inflation rate
Pe(t+1) is the expected price level in the next period
P(t) is the price level in this period
What does money deal with the issue of? What does this mean?
It deals with the double coincidence of wants which is when you have to find a person who wants what you have to trade
CPI and the GDP deflator can both be used to measure __________ however the _________ rates we derive will not be _________-
inflation
inflation
the same
Why will the inflation rates derived from the CPI and GDP deflator not be the same?
- because the CPI includes some foreign goods (imports) whereas the GDP deflator does not
- CPI basket is fixed (and rarely changes) whereas the GDP deflator measures the prices of all goods and services currently produced
How can we use the CPI to correct nominal measures important to consumers for inflation?
by using the equation real value(t) = 100 x (nominal value (t)/CPI(t)
How can we CPI and wage to see is people are better off after a number of years?
You can divide the wage by the CPI of the respective year and then multiply each by 100. Then you can see which one is bigger to see if you are better
What is the Fisher equation?
r = i - Π
where r is the real interest rate
i is the nominal interest rate
Π is the inflation rate
What is the real interest rate?
the interest rate adjusted for price changes
What is the nominal interest rate?
the interest rate is the contract rate on a money loan, incorporating the expected changes in price
The nominal interest rate (i) is the contract rate on a money loan. If you have a one year loan of $1000 at 5% one year, this means you get $1000 now but how much do you have to repay in one year? When there is inflation, the repaid money is worth more/not worth are much so it buys more/fewer things
you have to repay $1050 in a year
the repaid money is not worth much so it buys fewer things
Suppose the nominal rate is 7% and the inflation rate is 3%. What is the real rate?
r = i - Π r = 7-3 = 4%
Suppose the nominal rate is 7% and the inflation rate is 10%. What is the real rate? What does this mean?
r = i - Π r = 7-10 = -3%
This means you are 3% worse off than before
Unexpected inflation reduces _______, ______ and has _______ consequences
inflation
growth
distributional
Unexpected inflation distorts signals from _______ prices
relative
Unexpected inflation distorts the _______ system
tax
Unexpected inflation causes unexpected ________. What does this mean?
redistribution
This means that workers without indexed wages lose and borrowers gain at the cost of lenders
Unexpected inflation causes uncertainty for long term planning which reduces what?
investment
Why does unexpected inflation lead to more trips to the bank?
because interest rates are higher
Usually, nominal interest rates account for expected inflation. i = r* + Πe where r* = desired real interest rate. r = i - Π -> r = r* + (Πe - Π) -> (r-r*) = (Πe - Π). What is (r-r*)? What is (Πe - Π)?
(r-r*) is the extra real benefit to the lender
(Πe - Π) is the error int he inflation expectations
If (Πe - Π)>0, what does this mean?
the lender overcharged and benefits
If (Πe - Π)<0, what does this mean?
the lender undercharged and looses
