Chapter 17 - Monetary Growth and Inflation
Chapter 17 - Monetary Growth and Inflation Econ 110
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This 6 page Class Notes was uploaded by Erin Payne on Friday April 29, 2016. The Class Notes belongs to Econ 110 at Kansas State University taught by Dr. Al-Hamdi in Spring 2016. Since its upload, it has received 12 views. For similar materials see principles of Macroeconomics in Economcs at Kansas State University.
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Date Created: 04/29/16
Week 13 April 20th April 27th Spring 2016 Chapter 17 Notes Money Growth and Inflation ● Inflation ○ Increase in the overall level of prices. ● Deflation ○ Decrease in the overall rate of prices. ● Hyperinflation ○ Extraordinarily high rate of inflation. ● Classical Theory of Money ○ Quantity theory of money. ○ Explains the longrun determinants of price levels. ○ Explains the inflation rate. ● Value of Money = 1/P where P = price level. ● Inflation ○ Economywide phenomenon. ○ Concerns the value of the economy’s medium of exchange. ● Inflation: Rise in the Price Level ○ Lower value of money. ○ Each dollar buys a smaller quantity of goods and services. ● Quantity demanded of money is how much money out of their wealth that people want to keep with themselves in liquid form. ● Money Demand ○ Reflects how much money wealth people want to hold in liquid form. ○ Depends on: ■ Credit cards. ■ Availability of ATMs. ■ Interest rate. ■ Average level of prices in economy. (Greatest influencer because it determines for most how much liquid money you keep in your pocket.) ○ Demand curve downward slope. ● In Money Market: P↑ = Qd of Money↑ ○ ∴Because value of money = 1/P. If value of money↓, the Qd of money↑. ● Money Supply ○ Determined by the Fed and the banking system. ○ Supply curve is vertical. Notes Key:Bolded texts = most important facts stressed by professor. ∴ symbol = “Therefore” or “In other words”. “ ” = Specific definition or word choice provided y instructor. Week 13 April 20th April 27th Spring 2016 ● In the Long Run ○ Overall level of prices adjust. ■ To the level at which the demand for money equals the supply. ● Economy is in Equilibrium ○ If the Fed doubles the supply of money. ■ Prints bills. ■ Drops them on market. ○ Or the Fed: openmarket purchases. ○ New equilibrium. ■ Supply curve shifts right (an act of the central bank). ■ Value of money decreases. ■ Price level increases. ● Quantity Theory of Money ○ The quantity of money available in the economy determines (the value of money) the price level. ○ Growth rate in quantity of money available determines the inflation rate. ● Adjustment Process ○ Excess supply of money. ○ Increase in demand of goods and services. ○ Prices of goods and services increases. ○ Increase in price level. ○ Increase in the quantity of money demanded. ○ New equilibrium. ● Nominal Variables ○ Variables measured in money units. ○ Price = $100 ⇒ Nominal variables. ■ Ex. Dollar prices. ● Real Variables ○ Variables measure in physical units. ○ Quantity = 1 TV ⇒ Real variable. ■ Ex. Relative prices, real wages, real interest rate. ● Classical Dichotomy ○ Theoretical separation of nominal and real variables. Price of Item 1 ● Relative Price = Price of Item 2 ● Developments in the Monetary System ○ Influence nominal variables. ○ Irrelevant for explaining real variables. Notes Key:Bolded texts = most important facts stressed by professor. ∴ symbol = “Therefore” or “In other words”. “ ” = Specific definition or word choice provided by instructor. Week 13 April 20th April 27th Spring 2016 ● Monetary Neutrality ○ Changes in money supply don’t affect real variables. ○ Not completely realistic in shortrun. ○ Correct in the longrun. ○ ∴“Money affects nominal variables but not real variables.” ● Quantity Equation of Money: M * V = P * Y ○ Quantity of money (M). ○ Velocity of money (V). ○ P is the price level (P). ○ Real GDP (Y). ■ Dollar value of economy’s output of goods and services = P * Y. ○ Shows: an increase in the quantity of money. ■ Must be reflected in: ● Price level must rise. ● Quantity of output must rise. ● Velocity of money must fall. ● Velocity of Money (V) ○ Rate at which money changes hands. ○ V = (P * Y) / M. ■ P = Price level (GDP Deflator). ■ Y = Real GDP. ■ M = Quantity of Money. ● %ΔM +%ΔV = %ΔP +%ΔY ○ Assumption that V is constant. ○ %ΔM = Money growth rate. ○ %ΔP = Inflation rate. ○ %ΔY = Real GDP growth rate. ○ ∴Inflation rate = Money growth rate Real GDP growth rate. ● ∴“Inflation happens when the money growth rate is higher than the real GDP growth rate.” ● Quantity Theory of Money ○ Velocity of Money ■ Relatively stable over time. ○ Changes in quantity of money, M ■ Proportionate changes in nominal value of output (P * Y). ○ Economy’s output of goods & services, Y ■ Primarily determined by factor supplies. Notes Key Bolded texts = most important facts stressed by professor. ∴ symbol = “Therefore” or “In other words”. “ ” = Specific definition or word choice provided y instructor. Week 13 April 20th April 27th Spring 2016 ■ And available production technology. ■ Money does not affect output. ○ Changes in money supply, M ■ Induces proportional changes in the nominal value of output (P * Y). ● Reflected in changes in the price level (P). ○ When the central bank increases the money supply rapidly. ■ High rate of inflation. ● The Inflation Tax ○ Revenue the government raises by creating (printing) money. ○ Tax on everyone who holds money. ■ When the government prints money. ■ The price level rises. ■ And the dollars in your wallet are less valuable. ○ “Same effect as if they taxed you and physically took your money.” ● Principle of monetary neutrality. ○ An increase in the rate of money growth. ○ Raises the rate of inflation. ○ But does not affect any real variable. ● Real interest rate = Nominal interest rate Inflation rate. ● Nominal interest rate = Real interest rate + Inflation rate. ○ Remember: Nominal interest rate is a payment on a loan, and it is typically set when the loan is first made. ● Fisher Effect ○ Oneofone adjustment of nominal interest rate to inflation rate. ○ When the Fed increases the rate of money growth. ○ Longrun result. ■ Higher inflation rate. ■ Higher nominal interest rate. ● Inflation Fallacy ○ “Inflation robs people of the purchasing power of his hardearned dollars.” ○ ∴“As prices go up, so do the incomes of the people. Because of this, this is not the real cost of inflation.” ● When prices rise ○ Buyers pay more. ○ Sellers get more. ● Inflation does not in itself reduce people’s real purchasing power. ● Shoeleather Costs Notes Key:Bolded texts = most important facts stressed by professor. ∴ symbol = “Therefore” or “In other words”. “ ” = Specific definition or word choice provided by instructor. Week 13 April 20th April 27th Spring 2016 ○ Resources wasted when inflation encourages people to reduce their money holdings. ○ Can be substantial. ○ “A metaphor for the loss of resources necessary to protect your money.” ● Menu Costs ○ Costs of changing prices. ○ Inflation increases menu costs that firms must bear. ● Market Economies ○ Relative prices allocate scarce resources. ○ Consumers compare quality and prices of various goods and services. ■ Determine allocation of scarce factors of production. ○ Inflation distorts relative prices. ■ Consumer decisions are distorted. ■ Markets are less able to allocate resources to their best use. ● Taxes Distort Incentives ○ Many taxes: more problematic in the presence of inflation. ● Tax Treatment of Capital Gains ○ Capital gains are profits. ■ Sell an asset for more than its purchase price. ○ Inflation discourages saving. ■ Exaggerates the size of capital gains. ■ Increases the tax burden. ● Tax Treatment of Interest Income ○ Nominal interest earned on savings. ■ Treated as income. ■ Even though part of the nominal interest rate compensates for inflation. ● Higher Inflation ○ Tends to discourage people from saving. ● Confusion and Inconvenience ○ Money ■ Yardstick with which we measure economic transactions. ○ The Fed’s Job ■ Ensure the reliability of money. ○ When the Fed increases money supply ■ Creates inflation. ■ Erodes the real value of the unit of account. ● Redistribution of Wealth Notes Key:Bolded texts = most important facts stressed by professor. ∴ symbol = “Therefore” or “In other words”. “ ” = Specific definition or word choice provided b instructor. Week 13 April 20th April 27th Spring 2016 ○ Unexpected Inflation ■ Redistributes wealth among the population. ● Not by merit. ● Not by need. ■ Redistribute wealth among debtors and creditors. ○ Inflation: volatile and uncertain. ■ When the average rate of inflation is high. ● Deflation May Be Worse ○ Small and predictable amount of deflation. ■ May be desirable. ○ The Friedman rule: moderate deflation will. ■ Lower the nominal interest rate. ■ Reduce the cost of holding money. ■ Shoeleather costs of holding money minimized by a nominal interest rate close to zero. ● Deflation equal to the real interest rate. ● Costs of Deflation ○ Menu costs. ○ Relativeprice variability. ○ If not steady and predictable. ■ Redistribution of wealth toward creditors and away from debtors. ○ Arises because of broader macroeconomic difficulties. ■ Symptom of deeper economic problems. Notes Key: Bolded texts = most important facts stressed by professor. ∴ symbol = “Therefore” or “In other words”. “ ” = Specific definition or word choice provided by nstructor.
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