Week 5 Lecture 1 Flashcards
What is inflation?
Inflation is the increase in the overall level of prices
What is deflation?
Deflation is the decrease in the overall level of prices
What is hyperinflation?
Hyperinflation is an extraordinarily high rate of inflation such as Zimbabwe in the late 2000s
What effects does inflation have?
Inflation means that:
1- People have to pay more for goods and services
2- The value of money (the quantity of goods you can buy with £1) is reduced
What determines the value of money?
Money demand and money supply determines the value of money
What is money supply determined by?
Money supply is determined by the Central Bank (CB) via eg. OMOs
What is Money Demand determined by?
- The demand for money depends on the average level of prices (P) in the economy
- A higher value of P = lower value of money (1/P)
How does the price level (P) adjust in the long run?
In the long run the price level P adjusts to the level at which the demand for money equals the supply
Draw a diagram to show how the supply and demand for money determines the equilibrium price level
See slide 11 in Week 5 lecture 1
Draw a diagram to show the effects of the CB increasing the money supply
See slide 13 in Week 5 Lecture 1
Explain the adjustment process that occurs after the CB increases the money supply (explanation for the diagram)
- The excess supply of money leads to an increase in the demand for goods and services
- Prices of goods and services increase since the economy’s ability to supply goods and services is not affected by the money supply in the long run
- The increase in prices leads to an increase in quantity of money demanded (we slide down the demand curve)
- This leads to a new equilibrium
What is the quantity theory of money?
The quantity theory of money is the quantity of money available in the economy that determines the price level (the value of money)
What are nominal variables, real variables and classical dichotomy?
- Nominal variables are variables that are measured in monetary units
- Real variables are variables that are measured in physical units
- Classical dichotomy is a theoretical separation of nominal and real variables
State the quantity equation and each of its variables
Quantity equation: MV = PY
- M is the quantity of money
- (P*Y) is the pound value of the economy’s output of goods and services (nominal GDP)
- V is the velocity of money which is the rate at which money changes hands in the economy
Explain how the quantity equation explains the quantity theory of money
1- The velocity of money stays relatively stable over time
2- The economy’s real output of goods and services (Y) does not depend on nominal variables in the long run
3- So a change in the money supply (M) will be reflected in changes in the price level (P)
4- It follows that if the CB increases the money supply rapidly, this will lead to a large increase in the price level (P) until the new higher price level has been reached
What is money neutrality?
Money neutrality is the idea that an increase in the rate of money growth raises the rate of inflation but does not affect any real variable
State the formulas for calculating the real and nominal interest rates
- Real interest rate = Nominal interest rate - Inflation rate
- Nominal interest rate = Real interest rate + Inflation rate
What is the Fisher effect?
The Fisher effect is the idea that there is a one-for-one adjustment of nominal interest rate to inflation rate with increases or decreases in the rate of money growth
Does the Fisher effect hold in the short run?
The Fisher effect does not hold in the short run
What is inflation tax?
- Inflation tax is revenue the government raises by creating (issuing) money rather than raising taxes or selling bonds
- It is essentially a tax on everyone who holds money as when the government prints money the price level rises and the £ in your wallet is less valuable
What are some of the drawbacks of inflation when it is steady and predictable?
- Shoeleather costs: Resources wasted when there is inflation as people are encouraged to reduce their money holdings to minimise the costs of the inflation tax
- Menu costs: Costs of changing prices
- Inflation distorts relative prices which makes markets less capable of allocating resources to their best use as consumer decisions are also distorted
When inflation is unexpected what is a drawback?
It redistributes wealth from creditors to debtors whenever loans are specified in pounds
What are some drawbacks of deflation?
As it is cheaper to spend tomorrow, spending and investing is deferred so less is produced and a downward cycle is created
