Macro (Test 2) chapter 17 (Money Growth and Inflation)

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1. The classical Theory of Inflation (level of prices and the value of money)( Money Supply, Money Demand, and Monetary Equilibrium)-GRAPH 2. The effects of a Monetary Injection and the adjustment process. 3. The classical Dichotomy and Monetary Neutrality 4. Velocity and the Quantity Equation 5.The Inflation Tax and The Fisher Effect 6.The cost of inflation( A fall in purchasing power? The inflation fallacy) and (shoeleather costs) and (menu cost) 7. (Relative-Price variability and the misalloc…

5 steps are the essence of the quantity Theory of money

1. The velocity of money is relatively stable over time

2. Because velocity is stable, when the central bank changes the quantity of money (M), it causes proportionate changes in the nominal value of output (P x Y)

3. The economy's output of goods and services (Y) is primarily determined by factor supplies (labor, physical capital, human capital, and natural resources) and the available production technology. In particular, because money is neutral, money does not affect output.

4. With output (Y) determined by factor supplies and technology, when the central bank alters money supply(M) and induces proportional changes in the nominal value of output (P x Y), these changes are are reflected in changes in the price level (P).

5. Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation

****explains the equilibrium price level and inflation

A Brief look at the Adjustment process

the immediate effect of a monetary injection is to create an excess supply of money. B4 the injection, the economy was at equilibrium but after the injection people now have more dollars in there wallet than they want. At the prevailing price level, the quantity of money supplied now exceeds the quantity of demand.

-may use to buy bonds or make loans which increases the demand for goods and services

-The economies ability to supply goods and services, however, has not changed( available labor, physical capital, NR, and technological knowledge are not affected)

***The greater demand for goods and services causes the prices of goods and services to increase. The increase in price level, in-turn,increases the quantity of money demanded because people are are using more dollars for every transaction. Eventually the economy reaches a new equilibrium at which the quantity demanded equals the quantity of money supplied. **In this way the overall price level for goods and services adjusts to bring money supply and money demand into balance

Changes in the supply of Money

according to classical analysis, affect nominal variables but not real ones. When the Central bank doubles the money supply, the price level doubles, the dollar wage doubles, and all other dollar values double. Real variables, such a production, employment, real wages, and real interest rates, are unchanged.
***The irrelevance of monetary changes for real variables is called Monetary Neutrality

-most economist believe that over short periods of time within a year or two monetary changes affect real variables yet classical analysis is right about the economy in the long run . Monetary changes have a significant affect nominal variables such as price level
**the neutrality of money offers a good description of how long run changes in the economy

The Classical Dichotomy and Monetary Neutrality

economic variables divided into two groups
-Nominal variables=variables that are measured in monetary units(dollar prices)
-Real variables= Variables measured in physical units(relative price

-the separation of real and nominal variables is now called the classical dichotomy

relative price- the price of one thing compared to another (not measured in terms of money) When comparing the price of two goods the dollar sign cancels out

-The Real wage(the dollar wage adjusted for inflation)=it measures the rate people exchange goods and services for a unit of labor

**The real interest rate( the nominal interest rate adjusted for inflation) is a real variable because it measures the rate at which people exchange goods and services today for goods and services in the future

-according to classical analysis, nominal variables are influenced by developments in the economy monetary system, whereas money is largely irrelevant for explaining real variables

-The real interest rate balances the supply and demand for loanable funds, the real wage balances the s&d for labor, and unemployment results when the real wage is for some reason kept above equilibrium(These changes have nothing to do with money)

Classical theory of Inflation

developed by some of the earliest economic thinkers but most economist today rely on this theory to explain the long run determinants of the price level and the inflation rate

Confusion and Inconvenience

The job of the Fed is to ensure reliability of a commonly used unit of measurement. When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account
-accountants incorrectly measure firms' earnings when prices are rising over time. Because inflation causes dollars at different times to have different real values, computing a firms' profit- the difference between its revenue costs- is more complicated in an economy with inflation. ****Therefore to some extent, inflation makes investors less able to sort successful from unsuccessful firms, which in turn impedes financial markets in their role of allocating the economy's saving to alternative types of investment

The effects of a monetary injection

In an economy that is at equilibrium and suddenly the Fed injects money into the economy by buying some government bonds from the public in open market operations.

-The monetary injection shifts the supply curve to the right from MS1 to MS2. As a result the equilibrium moves down and the value of money(shown on the left axis) decreases and the equilibrium price level (shown on the right axis) increases
*****When an increase in the money supply makes dollars more plentiful, the result is an increase in price level that makes each dollar less valuable
***** this explanation of how the price level is determined and why it might change over time is called the Quantity Theory of Money

A Fall in Purchasing power? The inflation fallacy

When prices rise, buyers of goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. Because most people earn their incomes by selling their services, such as their labor, inflation in incomes goes hand in hand with inflation in prices. Thus inflation does not in itself reduce peoples real purchasing power

Fisher effect

the one-for-one adjustment of the nominal interest rate to the inflation rate.

Nominal Interest rate=real ir+ inflation
-this way of looking at nominal interest rate is useful because different economic forces determine each of the two terms on the right side of the equation
-the supply and demand for loanable funds determine real ir
-according tot he quantity theory of money, growth on the money supply determines the inflation rate
****When the FED increases the rate of money growth, the long run result is both a higher inflation rate and a higher nominal interest rate

Graph for Equilibrium price level

-horizontal axis shows the quantity of money
-The left vertical axis shows the value of money 1/P ( numbers go up)
-the right axis shows the price level P (inverted numbers go down) low at top, high at bottom
*** the inverted axis shows when the value of money is high (as shown near the top of the left axis), the price level is low (as shown near the top of the right access)

-Two curves for supply and demand
**the supply curve is vertical because the Fed has fixed the quantity of money
-The demand curve for money is downward sloping , indicating that when the value of money is low,( and the price level is high), people demand a larger quantity of goods and services
******This equilibrium of money supply and money demand determines the value of money and the price level

hyperinflation

an extraordinary high rate of inflation

Inflation

The increase in the overall level of prices
(may seem inevitable but its not. during 1900's deflation occurred)
-public views high rates of inflation as a major economic problem
-all economist decry hyperinflation, some economist argue that the costs of moderate inflation are not nearly as large as the public believes

Inflation is bad but Deflation May be worse

Deflation would lower the nominal interest rate (recall the Fischer effect) and that a lower nominal interest rate would reduce the cost of holding money. The shoeleather costs of holding money would be minimized by a nominal interest rate close to zero, which in turn would require deflation equal to the real interest rate

***DEflation has cost similar to inflation. Just as a rising price level induces menu costs and relative-price variability, so does falling price level
-moreover, in practice, deflation isn't really as steady and predictable as thought.
***more often it comes as a surprise, resulting in the redistribution of wealth toward creditors and away from debtors. Because debtors are more often poorer, these redistributions in wealth are particularly pernicious

****Deflation is often a symptom of deeper economic problems

Inflation Tax

the revenue the government raises by creating money ( helps build roads pay soldiers etc.)

Gov can turn to printing money to pay for its spending, the massive increases in quantity of money lead to massive inflation. Inflation ends when gov. institutes fiscal reforms such as cuts in spending

Inflation-Induced Tax Distortions

Almsot all taxes distort incentives
Lawmakers fail to take inflation into account when writing tax laws so taxes become more problematic in the presence of inflation
-Inflation exaggerates the size of capital gains and inadvertently increases the tax burden on this type of income
-the income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation
-because the after-tax real interest rate provides the incentive to save, saving is much less attractive in the economy with inflation
-The taxes on nominal capital gains and on nominal interest income are two examples of how the tax code interacts with inflation
***When inflation raises the tax burden on saving it tends to depress the economy's long-run growth rate
-ideal world tax laws would be written so that inflation would not alter anyones tax liability

The Level of Prices and the Value of money

-inflation is more about the value of money than about the price of goods.( possibly people enjoy ice cream more but more likely peoples enjoyment remained the same and the money overtime has become less valuable)

-Inflation is an economy-wide phenomenon that concerns, first and foremost, the value of money.(CPI rose by 3% last month, led by a 20% rise in the price of coffee. just information about the economy not inflation per say)

2 ways to view the economy's overall price level
-prive level as the price of a basket of goods and services (CPI)
-*view the price level as a measure of the value of money ( a rise in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services

-P measures the number of dollars needed to buy a basket of goods and services in CPI and GDP deflator
***** turned around the quantity of goods and services that can be bought with $1 equals 1/P
-1/P is the value of money measured in goods and services.

-The actual economy uses thousands of goods and services, so we use a price index rather than the price of a single good. But Logic stays the same:***When overall price level rises, the value of money falls

Menu Cost

the cost of changing prices
-inflation increases the menu costs that firms must bear

Money Supply, Money Demand, and Monetary Equilibrium

supply and demand determines the value of money (Just as supply and demand for apples determines the price of apples. The supply and demand for money determines the value for money)

-the quantity of money supplied is a policy that the FED controls
-The demand for money reflects how much wealth people want to hold in liquid form( there are many factors for how much currency people hold in their wallets, such as how much they rely on credit cards or the location of an atm)

-the quantity of money demanded depends on the interest rate that a person could earn by using the money to buy an interest-bearing bond rather than leaving it in a wallet or low-interest checking account

-most important variable that affects the demand for money is the average level of prices in the economy. money is the medium of exchange so people can buy easily
***** A higher price level( a lower value of money) increases the quantity of money demanded

What ensure the quantity of money the FED supplies balances the quantity of money demanded?
-short term=interest rates play a key role
****- Long run= The overall level of prices adjust to the level at which the demand for money equals the supply
**** If the price level is above the equilibrium level, people want to hold more money than the FED has created, so the price level must must fall to balance out supply and demand.

-At the equilibrium price level, the quantity of money that people want to hold exactly balances the quantity of money supplied by the FED

Quantity Equation

the equation M x V = P x Y, which relates the quantity of money, the velocity of money, and the dollar value of the economy's output of goods and services
M=quantity of money
V=the velocity of money
P=the price of output
Y= the amount of output

The equation shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables: The price level must rise, the quantity of output must rise, or the velocity of money must fall

-constant velocity may be a good approximation

The Quantity Theory of money

a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money determines the inflation rate
**growth in the quantity of money is the primary cause of inflation

the quantity theory of money (classical theory)

prices rise when the government prints to much money
-can explain moderate inflations such as those experience in the US, as well as hyper inflations

Relative-Price Variability and the Misallocation of Resource's

Because prices change once in a while, inflation causes relative prices to vary more they other wise would, This matters because market economies rely on relative prices to allocate scarce resources. Consumers decide what to buy by comparing the quality and prices of various goods and services. Through these decisions, they determine how the scarce factors of production are allocated among industries in firms. When inflation distorts relative prices, consumer decisions are distorted, and the markets are less able to allocate resources to their best use.

Shoeleather Cost

the resources wasted when inflation encourages people to reduce their money holdings

-inflation tax causes deadweight losses because people wast scarce resources trying to avoid it

**The actual cost of reducing money holdings is not the wear and tear on your shoes but the time and connivence you must sacrifice to keep less money on hand than you would if no inflation

A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth

Unexpected inflation redistributed wealth among the population in a way that has nothing to do with either merit or need . Theses redistributions occur because many loans in the economy are specified in term of the unit account-money

-Inflation is especially volatile and uncertain when the average rate of inflation is high

-countries with high average inflation, such as many countries in Latin American, tend to have unstable inflation. There are no known examples of economies with high,stable inflation. This relationship between the level and volatility of inflation points to another cost of inflation. If a country pursues a high-inflation monetary policy, it will have to bear not only the costs of high expected inflation but also the arbitrary redistribution of wealth associated with inflation

Velocity of Money

the rate at which money changes hands
-to calculate, we divide the nominal value of output (nominal GDP) by the quantity of money.
-If P is the price level (the GDP Deflator) , Y the quantity of output (Real GDP), and M the quantity of money, then Velocity is
**** Y=(P x Y) / M

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