Int Macro Econ Inflation effects
Int Macro Econ Inflation effects Economics 5570
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This 3 page Class Notes was uploaded by Ashish Kondoju on Saturday March 12, 2016. The Class Notes belongs to Economics 5570 at Wayne State University taught by Shuan Jung in Spring 2016. Since its upload, it has received 45 views. For similar materials see Intermediate Macroeconomics in Economcs at Wayne State University.
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Date Created: 03/12/16
Inflation Effects Seigniorage To spend more without raising taxes or selling bonds, the govt can print money. The “revenue” raised from printing money is called seigniorage. (pronounced SEEN-your-idge). The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i – π The Fisher effect The Fisher equation: i = r + π Chapter 3: S = I determines r . Hence, an increase in π causes an equal increase in i. This one-for-one relationship is called the Fisher effect. Two real interest rates Notation: π = actual inflation rate (not known until after it has occurred) Eπ = expected inflation rate Two real interest rates: i – Eπ = ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan i – π = ex post real interest rate: the real interest rate actually realized Money demand and the nominal interest rate In the quantity theory of money, the demand for real money balances depends only on real income Y. Another determinant of money demand: the nominal interest rate, i. the opportunity cost of holding money (instead of bonds or other interest-earning assets). So, money demand depends negatively on i. The money demand function (M/P ) = real money demand, depends negatively on i i is the opp. cost of holding money positively on Y higher Y increases spending on g&s, so increases need for money (“L” is used for the money demand function because money is the most liquid asset.) When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r + Eπ. Equilibrium For given values of r, Y, and Eπ , a change in M causes P to change by the same percentage—just like in the quantity theory of money. Over the long run, people don’t consistently over- or under-forecast inflation, so Eπ = π on average. In the short run, Eπ may change when people get new information. E.g.: The Fed announces it will increase M next year. People will expect next year’s P to be higher, so Eπ rises. This affects P now, even though M hasn’t changed yet...
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