EC 111- Week 10 Notes
EC 111- Week 10 Notes Econ 111
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This 2 page Class Notes was uploaded by Matt Cutler on Friday April 1, 2016. The Class Notes belongs to Econ 111 at University of Alabama - Tuscaloosa taught by Kent 0. Zirlott in Fall 2016. Since its upload, it has received 37 views.
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Date Created: 04/01/16
Money and Inflation Monday, March 28, 2016 3:30 PM • This chapter introduces the quantity theory of money to explain long run behavior of inflation 1. The Value of Money a. P=the price level (I.e CPI or GDP Deflator, most often CPI Index) i. P is the price of a basket of goods, measured in money b. 1/P is the value of $1, measured in goods i. Ex: basket contains one candy bar 1) If P=$2, value of $1 is 1/2 candy bar 2) If P=$3, value of $1 is 1/3 candy bar c. Inflation drives up prices and drives down the value of money 2. Money Supply (MS) a. In the real world, the MS is determined by Federal Reserve, the banking system, and consumers b. In this model, we assume the Fed precisely controls MS and sets it at some fixed amount 3. Money Demand (MD) a. Refers to how much wealth people want to hold in liquid form b. Depends on P i. An increase in P reduces the value of money, so more money is required to buy G and S ii. Thus, Quantity of money demanded is negatively related to the value of money and positively related to P, other things equal 1) Other things= real income, interest rates, availability of ATMs 4. MS and MD diagram a. Increasing MS causes P to rise, how? i. At the initial P, an increase in MS causes excess supply of money ii. People get rid of their excess money by spending it on G&S or by loaning it to others, who spend it. Result: increased demand for goods iii. But supply of goods does not increase, so prices must rise 5. Real vs. Nominal Variables a. Nominal variables- measured in monetary units (dollars and cents) i. Ex: nominal GDP Price is a nominal variable!!!! ii. Nominal interest rate (rate of return measured in $$$$) iii. Nominal Wage- price of labor b. Real Variables- measured in physical units A relative Price is a real variable!!! i. Ex: real GDP ii. Real interest rates (measured in output) iii. Real Wage= price of G&S 6. The Classic Dichotomy a. Classic Dichotomy: the theoretical separation of nominal and real variables b. Hume and the classical economists suggested that monetary developments affect nominal variables but not real variables c. If central bank doubles the money supply, Hume & classical thinkers contend: i. All nominal variables- including prices- will double ii. All real variables- including relative prices- will remain unchanged 7. The Neutrality of Money a. Monetary neutrality: the proposition that changes in the money supply do not affect real variables b. Doubling money supply causes all nominal prices to double; what happens to relative prices? c. Initially, relative price of cd in terms of pizza is price of cd/price of pizza (15/10) d. Nominal prices double = (30/20) e. Relative price is unchanged 8. The Velocity of Money a. Velocity of money: the rate at which money changes hands b. Notation: i. P x Y= Nominal GDP 1) = (price level) x (Real GDP) 2) M= Money supply 3) V= Velocity c. Velocity Formula: i. V= (P x Y)/ M M= Money supply ii. The quantity Equation (Represents the entire economy) V= Velocity 1) Multiply both sides by M: P= Price level (generally CPI) a) M x V= P x Y Y= Real GDP d. The Quantity Theory in 5 Steps: i. V is stable ii. So, a change in M causes nominal GDP (P x Y) to change by the same percentage EC 111 Page 1 ii. So, a change in M causes nominal GDP (P x Y) to change by the same percentage iii. A change in M does not affect Y: money is neutral, Y is determined by technology and resources iv. So, P changes by same percentages as P x Y and M v. Rapid money supply growth causes rapid inflation e. Summary i. If real GDP (Y) is constant, then inflation rate= money growth rate ii. If real GDP (Y) is growing, then inflation rate < money growth rate iii. Bottom line: 1) Economic growth increases # of transactions 2) Some money growth is needed for these extra transactions 3) Excessive money growth causes inflation 9. Hyperinflation ○ Generally defined as inflation exceeding 50% per month Caused by government massively printing money 10. The Inflation Tax a. When tax revenue is inadequate and ability to borrow is limited, govt may print money to pay for its spending b. Almost all hyperinflations start this way c. The revenue from printing money is the inflation tax: printing money causes inflation, which is like a tax on everyone who holds money. d. In the U.S., the inflation tax today accounts for less than 3% of total revenue 11. The Fisher Effect ○ Nominal Interest rate= Inflation rate + Real interest rate a. In the long run, money is neutral, so a change in the money growth rate affects the inflation rate but not the real interest rate b. So, the nominal interest rate adjusts one-for-one with changes in the inflation rate c. This relationship is called the Fisher effect after Irving Fisher, who studied it d. The Fisher Effect i. An increase in inflation causes and equal increase in the nominal interest rate, so the real interest rate is unchanged. In other words, a 1% increase in inflation causes a 1% increase in the nominal interest rate. 12. The Costs of Inflation a. The inflation fallacy i. Most people think inflation erodes real incomes or their purchasing power b. But inflation is a general increase in prices of the things people buy and the things they sell (i.e. their labor), so incomes rise with inflation c. In the long run, real incomes are determined by real variables, such as human capital, physical capital, technology, and natural resources, not the inflation rate. d. So, nominal income= real income + inflation e. Shoeleather costs i. The resources wasted when inflation encourages people to reduce their money holdings ii. Includes the time and transactions costs of more frequent bank withdrawals f. Menu Costs Earning interest on your money helps offset i. The costs of changing prices inflation 1) Printing new menus, mailing new catalogs, etc… 2) Higher inflation causes more frequent price changes which leads to higher menu costs g. Misallocation of resources from relative-price variability i. Firms don’t all raise prices at the same time, so relative prices can vary… which distorts the allocation of resources h. Confusion & inconvenience i. Inflation changes the yardstick we use to measure transactions. ii. Complicates long-range planning and the comparison of dollar amounts over time. i. Tax Distortions: After-tax nominal interest rate= nominal interest i. Inflation makes nominal income grow faster than real income rate- (tax rate(decimal)*Nominalinterest rate) ii. Taxes are based on nominal income, and some are not adjusted for inflation Real after-tax interest rate= After-tax nominal iii. So, inflation causes people to pay more taxes even when their real incomes don't increase interest rate- inflation rate j. Summary i. Inflation 1) Raises nominal interest rates (Fisher effect) but not real interest rates 2) Increases savers' tax burdens 3) Lowers the after-tax real interest rate 13. A Special Cost of Unexpected Inflation EC 111 Page 2