week 5

Question 1

define inflation

Answer 1

An increase in the overall level of prices

Question 2

define deflation

Answer 2

Decrease in the overall level of prices

Question 3

define hyperinflation w examples

Answer 3

Extraordinarily high rate of inflation

• Germany in the 1930s
• Yugoslavia in early 1990s
• Zimbabwe in late 2000s ~ 231,000,000% in June 2008

Question 4

Inflation (a rise in the price level, P) means that… [2]

Answer 4

1. People have to pay more for goods and services. Or put in a different but entirely equivalent way:
2. The value of money 1/P (the quantity of goods you can buy with £1) is reduced

Question 5

WHAT equilibrates money supply and **money demand in the short run and in the long run?

Answer 5

Short Run: Interest rates adjust to balance money supply and money demand.

Long Run: The price level adjusts to balance money supply and money demand, as money is neutral in the long run and does not affect real variables.

Question 6

What determines Inflation? [2]

in the Classical Theory of Money

Answer 6

classical theory of money:

1. Money supply

– Determined by CB, e.g. via OMOs, and the banking system (the money multiplier)

–- We will treat the supply curve as vertical and as a policy variable determined by the Central Bank

2. Money demand

– Determined by amount of wealth ppl want to hold as money, primarily in order to buy goods/services.

– The demand for money depends on the average level of prices, P, in the economy

• Higher P = lower value of money 1/P which increases demand as people need more £ to buy goods/services

Question 7

In the long run… what happens to higher price levels P?

Answer 7

price level P adjusts to the level at which the demand for money = the supply

Question 8

Effect of a Monetary Injection

show through a diagram

Imagine that the CB doubles the supply of money

Answer 8

CB DOUBLES SUPPLY OF MONEY - E.g. conducts OMOs & buys government bonds

(Or private bonds (unconventional monetary policy))
- Or reduces reserve requirements to accomplish the same

Question 9

explain this diagram

Answer 9

• The adjustment process→ EXCESS SUPPLY of money leads to an increase in the demand for goods and services→ Prices of goods and services increase; as the economy’s ability to supply goods and services is not affected by the money supply in the long run (in the long run it is determined by L, K, A, etc.)→ The increase in prices leads to an increase in quantity of money demanded (“we slide down the demand curve”)

New equilibrium

Note: the monetary injection does not affect real GDP, employment, real interest rates, etc., in the long run.

Question 10

what is the “quantity theory of money”?

Answer 10

The quantity of money available in the economy determines the price level (the value of money)

Growth rate in quantity of money determines the inflation rate

Question 11

who said “Inflation is always and everywhere a monetary phenomenon”

Answer 11

FRIEDMAN

Question 12

what are Nominal variables ?

Answer 12

Variables measured in monetary units

• Pound, dollar, euro prices

Question 13

what are Real variables?

Answer 13

Variables measured in physical units

i.e Quantities, relative prices, real wages, real interest rate

Real variables are not influenced by changes in the price level or inflation in the LR

Question 14

wat is the Classical dichotomy ?

Answer 14

Theoretical separation of nominal and real variables

changes in the money supply affect only nominal variables and have no impact on real variables in the long run.

This implies that monetary policy can influence prices but not real economic activity such as output or employment over the long term. (monetary neutrality) Critics argue that in the short run, monetary changes can affect real variables due to price and wage rigidities and economic expectations

Question 15

define monetary neutrality?

Answer 15

changes in money supply don’t affect real variables

Question 16

developments in the monetary system do what?

Answer 16

→ Influence nominal variables

→ Irrelevant for explaining real variables

Question 17

WHAT is the quantity equation?

Answer 17

IF M increases and V, Y stay constant, P must increase!

Over the LR, V is fairly constant.

Question 18

What does this figure show?

Answer 18

the nominal value of output as measured by:

• nominal GDP
• Q of money measured by M2
• velocity money measured by their ratio

Notice that nominal GDP and the quantity of money have grown dramatically over this period, while velocity has been relatively stable.

Question 19

The velocity of money is generally…

Answer 19

relatively stable over time

Question 20

The Economy’s (real) output of goods & services, Y…?

Answer 20

→ Does not depend on nominal variables in the long run, as we have already discussed.

Question 21

a change in money supply, M is reflected in ________?

Answer 21

changes in the price level (P).

Question 22

It follows that if the CB increases the money supply rapidly…?

Answer 22

It leads to a large increase in price level P (inflation until the new, higher price level has been reached).

Question 23

what is the FISHER effect?

Answer 23

“There is a one-for-one adjustment of nominal interest rate to inflation rate with increases (or decreases) in the rate of money growth”

But Fisher effect does not hold in the short run, at least if inflation is unexpected

Question 24

How 2 calculate real + nominal interest rate?

Answer 24

Real interest rate = nominal IR - inflation rate

Nominal interest rate = real IR + inflation rate

Question 25

What determines real interest rate?

Answer 25

D and S for loanable fund

Question 26

According to quantity theory what determines inflation?

Answer 26

money growth determines inflation

This implies the so-called Fisher effect (Irving Fisher)

Question 27

WHY do we care about inflation?

Answer 27

The Inflation tax

Question 28

What is the inflation tax?

Answer 28

Revenue the government raises by creating (issuing) money, rather than raising taxes or selling bonds.

BASICALLY: (A tax on everyone who holds money)

When the government prints money
- The price level rises
- And the £ in your wallet is less valuable

Question 29

Why might inflation not in itself reduce people’s REAL purchasing power?

Answer 29

When prices rise → Buyers pay more

But wage earners get more too – at least if relative prices remain the same (which is of course doubtful!).

• So inflation does not, in itself reduce people’s real purchasing power

Question 30

Assuming that nominal incomes keep up with goods’ price increases, inflation is still a problem.

Why?

Answer 30

other ways through which inflation can impact incomes…

1. Shoe-leather costs
2. Menu costs
3. Messing up the yardstick, relative prices

The above costs of inflation apply even when inflation is steady and predictable

Question 31

How do shoe-leather costs impact incomes through inflation?

Answer 31

Resources are wasted when there is inflation; holding cash becomes less attractive when inflation erodes its purchasing power quickly so,

people withdraw smaller amounts at the bank, but visit more often

to minimise costs of the inflation tax

– these additional transactions can create significant costs, which are referred to as shoeleather costs.

Can be substantial
.

Question 32

how do Menu costs affect incomes via inflation?

Answer 32

Menu costs are the costs incurred by businesses when they change their prices.

Inflation increases menu costs that firms must bear.

Question 33

how does Messing up the yardstick, relative prices affect incomes via inflation?

Answer 33

Inflation distorts prices, making it harder for consumers to make informed decisions and for markets to allocate resources efficiently, leading to misallocation and lower economic growth.

Question 34

what does Unexpected (surprise) inflation do?

Answer 34

redistributes wealth among the population

NOT by merit + NOT by need

e.g
Creditors vs. Debtors: Debtors benefit because they repay loans with cheaper money, while creditors lose as the money repaid has less value.

Fixed Incomes: Those with fixed incomes lose purchasing power, while those with adjustable incomes may fare better.

Savers vs. Borrowers: Savers lose because their money’s value decreases, while borrowers benefit by repaying loans with less valuable money.

Question 35

how does unexpected inflation (the way inflation impacts incomes indirectly e.g. shoeleather) redistribute wealth?

Answer 35

• Redistributes wealth from creditors to debtors whenever loans are specified in £’s
  • Unexpected inflation reduces real value of debt, since the nominal interest rate is effectively too low

Question 36

deflation is problematic too… why?

Answer 36

It means it’s cheaper to spend tomorrow than today, so you defer spending and investing

⇒ less is produced, no houses bought, etc.

⇒ Downward cycle. Debt deflation (Minsky)

Question 37

In response to DEFLATION CB WILL..?

Answer 37

CB’s will reduce interest rates BUT they can only reduce them “so far”

=> little incentive for banks to lend money

Question 38

The money supply determines ______ in the ______

Answer 38

The money supply determines inflation in the long run

Question 39

How can money supply determined by inflation in LR be explained?

Answer 39

1. with a supply-demand diagram
2. with the quantity equation.

Question 40

monetary policy has profound short run effects on _______ like GDP and employment.

Answer 40

real variables

Question 41

What is monetary neutrality vs Classical dichotomy?

Answer 41

The concept of monetary neutrality is embedded within the classical dichotomy.

The classical dichotomy encompasses a broader separation of real and nominal variables (real variables are not affected by nominal variables like price lvl/inflation), while monetary neutrality specifically addresses the impact of changes in the money supply(M1/M2) on these variables.