topic 5 Flashcards
Define inflation?
A sustained increase in the GPL of G&S in an economy over a period of time
What is CPI?
the rate at which prices of G&S bought by households rise & fall
Main UK measures of inflation? (5)
CPI, PPI, HPI, index of private housing rental prices and construction output price indices
What is the Quantity Theory of Money(QToM)?
a simple theory linking inflation rate to the growth rate of the money supply
What is the velocity of money?
rate at which money circulates = the avg number of times a $bill changes hands in a given time period
Price level = ?
nGDP/rGDP
See notes
bit that gives inflation equation
Growth rate of a product = ?
Sum of growth rates
What does the QToM predict?
A one-for-one relation between change in money growth rate and change in inflation rate
What does the quantity theory of money imply? (2)
1) Countries with higher money growth should have higher inflation rates
2) The LR trend in a country’s inflation rate should be similar to the LR money growth rate.
See data in slides and notes on confronting QToM with data
now
Why in the short run do we observe a negative relationship between inflation and money supply growth?
if expected inflation rises, the CB may cut money supply to keep it steady & vice versa
What is Seignorage?
the revenue raised from printing money
Why is seignorage bad?
it causes inflation, and inflation acts like a tax on people who hold money
What is the relationship between inflation and i, and why?
since r is determined exgoenously by S=I, via the fisher equation there is a 1 for 1 relationship between inflation and nominal interest rate
See notes and slides for data
now
What is E(pi)?
expected inflation rate
What is an ex ante real interest rate?
i-E(pi) - the real interest rate people expect when they buy a bond or take out a loan
What is an ex post real interest rate?
i-pi - the real interest rate actually realised
Note
In QToM M/P only depends on Y, however in reality it also depends negatively on i, because i is the opportunity cost of holding money.
When is equilibrium in money market?
(M/P) = L(r+E(pi),Y)
ie supply of RMB = demand for RMB
How is M determined in the LR?
exogenously (by the Fed)
How is r determined in the LR?
adjusts so S=I
How is Y determined in the LR?
Y=F(K,L)
where K, L and Y are all fixed
How is P determined in the LR? and note?
Adjusts so M/P=L(i,Y)
If r, Y and E(pi) are all fixed, a change in M causes an equal change in P
See notes on expected inflation!!!
now
Why is inflation bad?
Common misconception is that is lowers real wage, however this is only in short run when wages are rigid
What is the classical view of inflation?
It is just a change in units of measurement
5 social costs of expected inflation?
1) Shoeleather costs
2) Menu costs
3) relative price distortions
4) unfair tax treatment
5) general inconvenience
SMURG
What are shoeleather costs?
costs and inconveniences of reducing money balances to avoid inflation. ie. high inflation rate means people dont want to hold lots of cash tf lots of trips to the bank to withdraw money
What are menu costs?
costs of having to change the prices on menus etc.
Explain what is meant by relative price distortions?
eg. firms only issue new catalogue once a year, but inflation changes throughout the year tf microeconomic inefficiencies
Explain what is meant by unfair tax treatment?
Some taxes not adjusted for inflation such as capital gains tax (see example)
Explain what is meant by general inconvenience?
eg. Inflation makes it hard to compare nominal values from different time periods
What are two costs of unexpected inflation?
1) Arbitrary redistribution of purchasing power
2) Increased uncertainty
Explain what is meant by arbitrary redistribution of purchasing power?
LT contracts are often estimated based on E(pi) tf if it is wrong some may win while others may lose
What is meant by increased uncertainty?
When inflation is high it is more unpredictable tf larger differences between inflation and expected inflation tf arbitrary redistribution of purchasing power is more likely tf increased uncertainty tf risk averse people become worse off
Benefit of inflation?
Better functioning labour markets - nominal wages are rarely reduced tf hindering labour market clearing tf inflation allows real wages to reach equilibrium without nominal wage cuts
Define hyperinflation?
inflation greater than or equal to 50% a month
Cause of hyperinflation?
Excessive money growth (printing too much money)
Solution to hyperinflation?
Stop printing money but this can then lead to fiscal constraints
What does the classical dichotomy argue?
that although nominal and real variables are related, nominal variables do not affect real variables
See notes below classical dichotomy
now
What does the classical dichotomy lead to?
Neutrality of money = changes in the money supply do not affect real variables tf in LR money is neutral
Explain an example of unfair tax treatment?
Buy £10K worth of stock 1st Jan
Sell if for £11K 31st December
But 10% inflation tf nominal gain=£1K but real gain =0
Still have to pay taxes on £1000 nominal gain!
(Capital gains tax)
