Week 7 Flashcards
Inflation
Inflation is an increase in the overall level of prices.
Deflation
Deflation is a decrease in the overall price level.
Hyperinflation
Hyperinflation is an extraordinarily high rate of inflation. Hyperinflation is inflation that exceeds 50 percent per month.
The Causes of Inflation
The level of prices and the value of money
Money supply, money demand and monetary equilibrium
What is the ‘easiest’ way to create high inflation?
Milton Friedman ‘Inflation is always and everywhere a monetary phenomenon.’
What does he mean?
The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.
Money supply
The money supply is a policy variable that is controlled by the central bank.
Through instruments such as open-market operations, the central bank directly controls the quantity of money supplied by the banking system.
Note that the RBA no longer targets the money supply. The RBA now targets interest rates and inflation.
Money demand
Money demand has several determinants, including interest rates and the average level of prices in the economy.
People hold money because it is the medium of exchange.
The amount of money people choose to hold depends on the prices of goods and services.
Nominal and real variables
Nominal variables are variables measured in monetary units.
Real variables are variables measured in constant units.
This separation is the classical dichotomy.
According to the classical dichotomy, different forces influence real and nominal variables.
The classical dichotomy and monetary neutrality
Real economic variables do not change with changes in the money supply.
Changes in the money supply affect nominal variables but not real variables.
The irrelevance of monetary changes for real variables is called monetary neutrality.
Velocity of money
The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.
Velocity (V)
= nominal GDP (P × Y) / money supply (M)
(P*Y)/M
The quantity equation
M * V = P * Y
Velocity and the quantity equation
The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of the three other variables:
the price level must rise
the quantity of output must rise, or
the velocity of money must fall.
Explaining the equilibrium price level, inflation rate and the quantity theory of money:
Assume the velocity of money is relatively stable over time.
When the central bank
changes the quantity of money, it causes proportionate changes in the nominal value of output (P * Y).
Because money is neutral, money does not affect output.
When the central bank alters the money supply, these changes are reflected in prices.
Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.
Is the velocity of money is relatively stable over time
Yes
Money neutrality
The irrelevance of monetary changes for real variables is called money neutrality.
The equilibrium price level
In the long run The overall level of prices adjusts to the level at which the demand for money equals the supply
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The effects of a monetary injection explained
An increase in the money supply decreases the value of money and increases the price level.
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Maintaining Price Stability
An increase in the money demand. The central bank increases money supply. No change in the value of money. Price level stays constant.
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inflation tax
An inflation tax is like a tax on everyone who holds money.
The Fisher effect
the Fisher effect: How does the nominal and real interest rate respond to the inflation rate?
Nominal interest rate = real interest rate + inflation rate
According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same.
Inflation-induced tax distortion
Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.
With progressive taxation, capital gains are taxed more heavily
The income tax system treats the nominal interest earned on savings as income
The after-tax real interest rate falls, making saving less attractive.
How inflation raises the tax burden on saving
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Confusion and inconvenience
Inflation causes dollars at different times to have different real values.
Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time
Arbitrary redistributions of wealth
Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.
These redistributions occur because many loans in the economy are specified in terms of the unit of account – money
Why do central banks commonly have inflation targets of around 2% rather than 0% (which would be perfect price stability)?
There are two main reasons:
Keeping well away from deflation
Being able to reduce interest rates by more in a downturn
Economists have identified 5 costs of inflation
Shoeleather costs
Menu costs
Confusion and inconvenience
Inflation-induced tax distortions
Relative-price variability and the misallocation of resources
P
Price Level (GDP Deflator)
Y
Real GDP
M
Quantity of money
When the central bank
changes the quantity of money, it causes proportionate changes in the nominal value of output (P * Y).
The economy’s output of goods and services (Y) is determined primarily by available resources and technology. Price level (P) increases proportionately with the change in M
The level of prices and the value of money
When the price level rises people have to pay more for the goods and services that they purchase. A rise in the price level also means that the value of money is now lower because each dollar now buys a smaller amount of goods and services. If P is the price level as measured by the CPI or the GDP deflator then the quantity of goods and services that can be purchased with $1 is equal to 1/P. If P increases, value of money (purchasing power) decreases.
Money supply, money demand and monetary equilibrium
The value of money is determined by the supply and demand for money.
The demand for money
Mainly determined by the price level. The higher prices are, the more money that is needed to perform transactions. A higher price level leads to a higher quantity of money demanded.
The supply of money
Determined by the central bank. The RBA no longer targets the money supply. Instead it targets interest rates and inflation. Assuming the central bank targets the supply of money, the supply of money will be vertical (perfectly inelastic.
In the long run The overall level of prices adjusts to the level at which the demand for money equals the supply
If the price level is above the equilibrium level, people will want to hold more money than is available and prices will have to decline. If the price level is below equilibrium, people will want to hold less money than that available and the price level will rise.
The effects of a monetary injection explained
The immediate effect of an increase in the money supply is to create an excess supply of money. People try to get rid of this excess supply by buying hoods and services with the funds or using these excess funds to make loans to others. The leads to increases in the demand for goods and services. Because the supply of goods and services has not changed, the result of an increase in the demand for goods and services will be higher prices.
The quantity theory of money
The quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate.
Shoeleather costs
Because inflation erodes the value of money that you can carry in your pocket, you can avoid this drop in value by holding less money. Holding less money generally means more trips to the bank. The resources wasted when inflation encourages people to reduce their money holdings.
Menu costs
During periods of inflation, firms must change their prices more often. The costs of changing prices.
Confusion and inconvenience
When inflation occurs the value of money falls. This alters the yardstick that we use to measure important variables like incomes and profit.
Inflation-induced tax distortions
Law-makers rarely take into account inflation when they write tax laws.
Relative-price variability and the misallocation of resources
Because prices of most goods change only once in a while (instead of constantly), inflation causes relative prices to vary more than they would otherwise. Consumer decisions are distorted and markets are less able to allocate resources efficiently.
- Two countries, Alpha and Beta, are otherwise identical except that each dollar in Alpha is used more frequently than each dollar in Beta. For this to be true, it must be the case that, holding other factors equal, __________ in Alpha than in Beta.
If both countries are identical then this means that trade and inflation is identical across both. According to the below “quantity theory of money” formula, this implies that only the velocity of money (number of times each dollar circulates) and stock of money varies between the nations. Hence, the nation with the higher velocity will have a smaller stock of money and vice versa.
Money stock x velocity = price level x quantity (production)
If both countries are identical then this means that trade and inflation is identical across both. According to the below “quantity theory of money” formula, this implies that only the velocity of money (number of times each dollar circulates) and stock of money varies between the nations. Hence, the nation with the higher velocity will have a smaller stock of money and vice versa.
Money stock x velocity = price level x quantity (production)
- According to the quantity equation, if velocity and real GDP are constant and the Reserve Bank increases the money supply by five per cent, then the price level
a. decreases by 10 per cent
b. decreases by five per cent
c. is also constant
d. increases by five percent
ANS: D
Money stock X Velocity = Price Level X RDGP
With RGDP and velocity held constant, a percentage change in money stock must be fully reflected in an equal percentage change in the price level.
- The demand for money is:
positively related to the price level
FOR ALL GRAPH 1 QUESTIONS
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- At point B in Graph 1:
a. the value of money is less than its equilibrium level
b. money supply is greater than money demand
c. the price level is higher than its equilibrium level
d. money demand is greater than money supply
At point B Money supply and money demand are not equal. The value of money is ½ at this point, the corresponding quantity of money demanded is equal to M1 (point A) whereas the quantity of money supplied is equal to M2 (point B). M2 is greater than M1, thus money supply is greater than money demand at this point
- When the money supply curve in Graph 1 shifts from MS2 to MS1:
a. the equilibrium value of money increases
b. the equilibrium price level increases
c. the supply of money has increased
d. the demand for goods and services will increase
ANS: A
- When the money supply curve in Graph 1 shifts from MS2 to MS1:
a. the equilibrium price level increases
b. this may be due to the RBA selling government securities
c. this is due to the RBA buying government securities
d. the demand for goods and services increasing
ANS: B
The value of money and the price level move in opposite directions. Each dollar is more valuable when it can be used to purchase a larger amount of goods and services. Thus, the value of money is higher when prices are lower. A decrease in the money supply (M2 to M1) achieved by the RBA selling government bonds will lead to an increase in the value of money (1/4 to ½) as inflationary pressures are reduced (as prices begin to fall).
- What is the classical dichotomy
The classical dichotomy refers to the division of all economic variables into two groups, nominal variables and real variables
- Define the quantity equation and illustrate how it affects the price level in the economy.
The quantity equation describes the relationship between money and nominal GDP. Recall that nominal GDP is the price level times real GDP. The quantity equation can then be written as money supply times velocity equal to price level times real GDP, or in symbols, M xV = P x Y.
