Friedman's Inflation Theory

Question 1

What is Inflation? How can this be measured?

Answer 1

• Inflation: The percentage change in the overall price level (2% aim in the UK)
• π = (Pt+1 - Pt) / Pt
• This is measured by CPI, RPI, CPIH or PPI
• Inflation is often damaging, paticularly when it causes hyperinflation (π>500%)

Question 2

What is the global trend for inflation? Why?

Answer 2

• Since 2000, inflation has generally fallen in most developed countries
• This is largely as a result of monetarism
• However, this was not the case in the COVID-19 pandemic, where the UK in particular saw >10%

Question 3

What is the link between the inflation rate and the price level?

Answer 3

• Lower inflation does not result in falling prices
• This is because inflation measures the RATE OF CHANGE in the price level, not just the price level

Question 4

What is the CPI? How can it be used? What are some key formulas used to compare periods?

Answer 4

• Consumer Price Index shows the change in the value of a select basket of goods
• Useful, as it can show us the value of something over two given periods
• Positive inflation means real difference>nominal difference
• We can use an inflator/deflator to compare different periods
• I.E. Original x CPI Base year/CPI in year α = PV
• I.E. New x CPI in year α/CPI Base year = PV

Question 5

Provide a brief history of money

Answer 5

• Money was initially backed by gold or silver, and this gave the value
• Currency is now ‘fiat money’, which is paper that Government declares is worth £x
• Money now has values due to social conventions

Question 6

How can we measure the Money Supply?

Answer 6

• 1; Monetary base includes currency and accounts (Banks hold accounts with the economy’s CB)
• Under the Ample Reserve Framework, banks in UK/US/EU have a new system
• This system differs from fractional reserve banking and instead offers a reserce requirement
• 2; M1, which is the money base + checking accounts (INCLUDES demand deposits)
• As the denomination of money increases, the liquidity falls (M4 is most illiquid)

Question 7

How has money become digitalised?

Answer 7

• Electronic forms of currency include debit cards, PayPal, Apple Pay …
• Digital money makes up a large sector in major economies
• Aggregate amount of money has not changed

Question 8

What is the equation for the Quantity Theory of Money (QToM)?

Answer 8

• MtVt = PtYt
• Where Mt is Money Supply, Vt is Money Velocity, Pt is the Price Level and Yt is the Real GDP
• Money used in purchases = Nominal GDP [spending = earnings]

Question 9

What does the QToM imply?

Answer 9

• Under classical dichotemy, real and nominal sides of the economy are different in the LR
• In QToM: RGDP is assumed to be exogenous, therefore Yt is Ytbar
• In QToM: Money Velocity is exogenously a constant, therefore Vt = Vbar
• In QToM: Money Supply is exogenous, therefore Mt is Mtbar
• This allows us to say that P* = MtbarVbar / Ytbar; implying that increases in P stem from Mtbar rising ot Ytbar falling

Question 10

How can growth rates be incorporated into the QToM?

Answer 10

• If MtVt = PtYt, then gMt + gVt = gPt + gYt
• As Vbar is a constant, gVt = 0 and gPt = π
• This means that π* = gMt - gYt
• As these values are constants, classical dichotemy tells us that changes in the growth rate of MS has a one-for-one change in the inflation rate

Question 11

Give three examples where QToM work in real life

Answer 11

• There are three different ways that the QToM has been compared
• We have seen smooth growth and low & stable inflation [NICE]; P&Y grow at low stable rates, M * V must grow at π+gY
• Excess money printing; M increases, V is constant and Y is uneffected, so P must increase rapidly
• COVID-19 Pandemic; Y and V fall but M increases- this doesn’t necessarily increase P

Question 12

How can classical dichotemy be evaluated?

Answer 12

• Changes in MS have no REAL effects on the economy, only prices. When prices change, relative prices are also unchanged
• Money neutrality only holds in the LR, not the SR; as price adjustments are costly and infrequent due to contractual agreements
• Y must respond to changes in M in the LR if P doesn’t change

Question 13

What is the difference between nominal and real IRs? What does this allow for?

Answer 13

• Nom IR = Actual IR agreed and paid. Unit = Currency
• Real IR = MPk. Unit = Goods or Services
• This allows for the fisher Equation, i = π + R
• Empirically, R has been negative; if in the SR real IR =/= MPk, prices and inflation is sticky
• Changes in i can affect R, starting point of MP

Question 14

What are some costs of inflation?

Answer 14

• Individuals are hurt by unexpected inflation- those who rely on pensions or those who have variable mortgages
• Winners and Losers are created by inflation- Borrowers WIN and Creditors LOSE, leading to wealth redistribution
• Fiscal drag increases some individual’s tax burden- taxes are based on nominal wage whilst decisions are based on real variables; meaning that tax distorions grow when inflation is high
• Relative Price Distortion- some prices are faster to react to inflation, menu cost mean that resources are inefficiently allocated

Question 15

Expand upon the ideal of an ‘inflation tax’

Answer 15

• Inflation Tax: The revenue the government is able to obtain from printing money
• Rise in the price level being paid by those holding cash
• If Governments run budget deficits, as debt increases, lending decreases due to uncertainty of repayment
• Rises in taxes might not be feasible, but printing money can be

Question 16

What is the Wage-Price Spiral? When did this happen?

Answer 16

• WPSpiral: Increased inflation, unions negotiate higher wages, increased CoP and increased prices, Unions demand higher wages and therefore pushes up prices
• This occurred in the 1950s/1960s in the USA