Macroeconomics 1BB3 - Chapter 12 - Money Growth and Inflation
TESTING QUESTIONS
QUESTIONS FOR REVIEW
Question 7
If the inflation is less than expected, who benefits - debtors or creditors? Explain.
Question 6
Which of these costs do you think are most important forthe Canadian economy?
What are the costs of inflation?
Question 5
According to the Fisher effect, how does an increasein the inflation rate affect the real interest rate andthe nominal interest rate?
Question 4
How does thinking about inflation help explainhyperinflation?
In what sense is inflation like a tax?
Question 3
According to the principles of monetery neutrality,which variables are affected by the changes in thequantity of money?
Explain the difference between nominal and realvariables, and give two examples of each
According to the quantity theory of money,what is the effect of an increase in the quantityof money?
Explain how an increase in the price level affectsthe real value of money
QUICK QUIZ
Question 2
List and describe six costs of inflation
Question 1
The government of a country increases the growth rate of the moneysupply from 5% per year to 50% per year.
Why might the government be doing this?
What happens to nominal interest rates?
What happens to prices?
EXTRA READING
IN THE NEWS
How to Protect Your Savings From Inflation
Inflation Fighters for the Long Term
The Hyperinflation in Serbia
Special, Today Only: 6 Million Dinarsfor a Snickers Bar
Russia Turns to the Inflation Tax
Russia's New Leaders Plan to Pay Debtsby Printing Money
CASE STUDY
Money Growth, Inflation, and the Bank of Canada
Money and Prices During Four Hyperinflations
FORMULAS
Interst Rates
Nominal interest rate = Real interest rate + Inflation rate
Real Interest rate = Nominal interest rate - Inflation rate
Quantity equation
Velocity of money equation
SUMMARY
Point 6
Many of these costs are large during hyperinflation,but the size of these costs for modeterate inflationis less clear.
Economists have indentified six costs of inflation:
and arbitrary redistributions of wealth betwen debtros and creditors
confusion and inconvenience resulting from a changing unit of account
unintended changes in tax liabilities due to nonindexation of the tax code
increased variability of relative prices
menu costs associated with more frequent adjustment of prices
shoeleather costs associated with reduced money holdings
Point 5
This view is a fallacy, however, because inflation also raises nominal incomes.
Many people think that inflation makes them poorer because it raises the cost of what they buy.
Point 4
According to the Fisher effect, when inflation rises, the nominal interest raterises by teh same amount, so that the real interest rate remains the same.
One application of the principle of monetary neutrality is the Fishereffect.
Point 3
When countries rely heavily on this "inflation tax," the result is hyperinflation
The government can pay for some it its spending by printing money.
Point 2
Most economists beleive that monetary neutrality approximatelydescribes the behaviour of the economy in the long run.
The principle of monetary neutrality asserts that changes in thequantity of money influence nominal variables but not real variables
Point 1
Persistant growth in the quantity of money supplied leadsto continuing inflation.
When the central bank increases teh supply of money, it caussthe price level to rise.
The overall level of prices in an economy adjusts to bringmoney supply and money demand into balance.
THE COSTS OF INFLATION
A SPECIAL COST OF UNEXPTECTED INFLATION:ARBITRARY REDISTRIBUTIONS OF WEALTH
CONFUSION AND INCONVENIENCE
INFLATION-INDUCED TAX DISTORTIONS
capital gains
RELATIVE-PRICE VARIABILITY AND THE MISALLOCATIONOF RESOURCES
MENU COSTS
SHOELEATHER COSTS
A FALL IN PURCHASING POWER? THE INFLATION FALLACY
inflation does not itself reduce people's realpurchasing power
MODELS
TABLE 12.1
How Inflation Raises the Tax Burdenon Savings
FIGURE 12.5
The Nominal Interest Rate and theInflation Rate
FIGURE 12.4
Money and Prices during FourHyperinflations
FIGURE 12.3
Nominal GDP, the Quantity of Money,and the Velocity of Money
FIGURE 12.2
An increase in the Money Supply
FIGURE 12.1
How the Supply and Demand for Money Determinethe Equilibrium Price Level
THE CLASSICAL THEORY OF INFLATION
THE FISHER EFFECT
when the Bank of Canada increases the rate of moneygrowth, the result is both a higher inflation rate and ahigher nominal interest rate
real interest rate
nominal interest rate
THE INFLATION TAX
the inflation tax is like a tax on everyone who holds money
VELOCITY AND THE QUANITY EQUATION
Quantity theory of Money
5 Steps for the essense of the
5. Therefore, when the central bank increases the money supplyrapidly, the result is a high rate of inflation
4. With output ( Y ) determined by factor supplies and technology,when the central bank alters the money supply ( M ) and inducespropotional changes in the nominal value of output ( P x Y ), thesechanges are reflected in changes in the price level ( P ).
3. The economy's output of goods and services ( Y ) isprimarily determined by factor supplies (labour, phyisicalcapital, human capital, and natural resources) and theavailable production technology. In particular becausemoney is neutral, money does not affect output.
2. Because velocity is stable, when the central bank changesthe quantity of money ( M ), it causes proportionate changesin the nominal value of output ( P x Y )
1. The velocity of money is relatively stable over time.
Quantity Equation
Where:M - quantity of moneyV - velocity of money( P x Y ) - nominal value of output)if:P - priceY - quantity of output
M x V = P x Y
relates the quantity of money to thenominal value of output
Velocity of Money Equation
V = ( P x Y ) / M
Where:V - velocity of moneyP - price level ( GDP deflator )Y - the quanitity of output ( real GDP )M - the quantity of money
nominal value of output ( nominal GDP)divided by the quantity of money
THE CLASSICAL DICHOTOMY AND MONETARY NETRALITY
actual
measured
relative
classical
dichotomy
A BRIEF LOOK AT THE ADJUSTMENT PROCESS
THE EFFECTS OF MONETARY INJECTION
MONEY SUPPLY, MONEY DEMAND, AND MONETARY EQUILIBRIUM
In the long run, the overall level of prices adjusts to the levelat which the demand for money equals the supply.
THE LEVEL OF PRICES AND THE VALUE OF MONEY
INTRODUCTION
hyperinflation
deflation
inflation
LEARNING OBJECTIVES
Consider the various costs that inflation imposeson society
Examine how the nominal interest rate respondsto the inflation rate
See why some countries print so much moneythat they experience hyperinflation
Learn the meaning of the classical dichotomyand monetary neutrality
See why inflation results from rapid growth inthe money supply
KEY TERMS
menu costs
the costs of changing prices
shoeleather costs
the resources wasted when inflation encouragespeople to reduce their money holdings
Fisher effect
the one-for-one adjustment of the nominal interestrate to the inflation rate
inflation tax
the revenue the government raises by creating money
quantity equation
the equation M x V = P x Y which relates the quantityof money, the velocity of money, and the dollar valueof the economy's output of goods and services
monetary neutrality
the proposition that changes in the money supplydo not affect real variables
classical dichotomy
the theoretical seperation of nominal and real variables
real variables
variables measured in physical units
nominal variables
variables measured in monetary units
quantity theory of money
a theory asserting that the quantity of money available determinesthe price level and that the growth rate in the quantity of money available determines the inflation rate
