Inflation and Deflation

Question 1

Definition of Deflation:

Answer 1

• Sustained period of negative inflation

Question 2

Definition of Hyperinflation:

Answer 2

• inflation of more than 50 percent per month (or roughly 13,000 percent per year)

Question 3

Definition of Velocity of money: (formula)

Answer 3

• Shows how quickly money moves through the economy
• Ratio of nominal GDP to the money supply:

( V = P . Y/ M )

• “V” stand for Velocity of money
• “P” stand for Price
• “Y” stand for Output
• “M” stand for Money Supply

Question 4

Definition Quantity equation of money: (Formula)

Answer 4

• relationship among the money supply, velocity, and nominal GDP:

M.V 􏰀= P.Y

• “V” stand for Velocity of money
• “P” stand for Price
• “Y” stand for Output
• “M” stand for Money Supply

Question 5

In the long run, two of the growth rates in the Quantity Equation of Money are outside the control of the central bank:

Answer 5

• Output
• Velocity

Question 6

Why the Output growth in the long-run is independent from central bank?

Answer 6

• Output growth depends on factors that affect the economy’s productivity, such as new technologies.
• Long-run neutrality means that monetary policy is irrelevant, therefore, the central bank.

Question 7

Why the Velocity growth in the long-run is independent from central bank?

Answer 7

• Long-run changes in velocity are driven primarily by changes in transaction technologies—the methods people use to acquire and spend money.
• Velocity moves in the opposite direction from money demand.
• Innovations such as ATMs have slowly reduced money demand, so velocity has risen.

Question 8

From Money Growth to Inflation (Graph)

Answer 8

• “i” stand for nominal interest rate
• “r” stand for real rate
• “AE” stand for aggregate expenditure
• “Y” stand for output
• “π” stand for inflation rate

Question 9

Determinants of Money Growth and Inflation (graph)

Answer 9

Question 10

what is Bimetallism?

Answer 10

• Monetary system in which money is backed by both gold and silver

Question 11

what is The Output–Inflation Trade-Off ?

Answer 11

• A central bank allows inflation to rise if it accommodates an adverse supply shock, such as a rise in oil prices.
• The aim of policymakers is not to raise output but merely to keep it from falling below potential.
• Then if the central bank want to return to the prevous equilibrium, it use desinflation policies
• desinflation policies created a temporally fall in output

Question 12

what is the definition “Printing money” for the central bank to the government?

Answer 12

• Financing government budget deficits by selling bonds to the central bank

Question 13

Definiton of “Seigniorage revenue”:

Answer 13

• Revenue the government receives from printing money

Question 14

what is the inflation fallacy ?

Answer 14

• a worker’s standard of living depends on her real wage (not nominal wage), the ratio of her/his wage to the aggregate price level.
• Inflation raises the numerator and denominator of this ratio by the same amount, so the real wage is unchanged.
• The real wage is determined by other factors, such as the worker’s productivity.

Question 15

which are the adverse effects of high inflation that economists have identified?

Answer 15

1. shoe leather costs
2. distracted firms
3. relative-price variability
4. income inequality

Question 16

Definition of Shoe leather costs:

Answer 16

• Inconveniences that result from holding less money when inflation is high.
• Lower money holdings mean that transactions become harder, making life less convenient.
• People try to minimize their money holdings so, they rush to buy goods as soon as they receive their pay to avoid the fast depreciation of it whealth.

Question 17

How “Distracted Firms” is one of the adverse effects of high inflation?

Answer 17

• firms try to minimize money holdings; they constantly move cash into bank accounts with interest that compensates for inflation.
• These activities consume managers’ time and attention. Coping with inflation leaves less time for normal business activities, such as developing new products or improving productivity

Question 18

what is “Relative-Price Variability” in an economy with high inflation?

Answer 18

• When inflation is high, all firms raise their prices by large amounts. But they do so at different times.
• Some prices are abnormally high compared to others, just because they have adjusted more recently. In other words, inflation causes dispersion in relative prices.

Question 19

How income inequality get worse with high inflation?

Answer 19

• The poor have relatively large money holdings. They receive their wages in cash and have no bank accounts, so inflation is costly.
• The rich have access to bank accounts with high nominal interest rates that compensate for inflation.
• The salaries of professional workers are often indexed to inflation
• The wages of unskilled workers are slower to adjust when inflation accelerates.

Question 20

why moderate inflation is stil harmful? (acording to some economist) (most important)

Answer 20

• Inflation Uncertainty
• Inflation and Taxes

Question 21

why Inflation Uncertainty is bad? (acording to some economist)

Answer 21

• Uncertainty about inflation creates risk in loan markets
• Wealth is redistributed between borrowers and lenders. This redistribution can harm the economy
• uncertainty about inflation discourages both borrowers and lenders from entering the loan market. Each group is deterred by the risk of redistributions.
• The financial system becomes less effective at channeling funds to investors from savers, hurting economic growth.

Question 22

why Inflation have an adverse effect in the tax proccess? (and secondary effect)

Answer 22

• When inflation rises, people pay higher taxes on the income they earn from savings.
• You pay taxes based on your nominal interest income. This income has risen, so you pay higher taxes on the same real income.
• When inflation raises these taxes, saving falls. The result is lower investment and lower economic growth.

Question 23

Definition of “After-tax real interest rate” (R¬):(formula)

Answer 23

• the interest rate adjusted for both taxes and inflation:

R¬ = (1 - m) r - m.pi

• “r” stand for real interest rate
• “pi” stand for inflation
• “m” stand for tax rate
• “R” stand for “After-tax real interest rate”

Question 24

Definition of “Liquidity trap”:

Answer 24

• situation in which output is below potential at a nominal interest rate of zero (a real interest rate of 􏰅-pi)
• Eliminating the central bank’s usual ability to raise output and inflation
• Zero-bound problem

Question 25

Definition Zero bound:

Answer 25

* The limit on the nominal interest rate; a central bank cannot reduce "i" below zero, which limits its ability to stimulate the economy

Question 26

A Liquidity Trap (graph)

Answer 26

Question 27

A Vicious Circle graph (liquidity trap)

Answer 27

Question 28

The Market for Money in a Liquidity Trap (graph)

Answer 28

Question 29

Proccess of a liquidity trap (steps)

Answer 29

1. Lower Bounds on Interest Rates 2. Role of Deflation 3. The Irrelevance of Money Growth

Question 30

what is the behabiour of the "Lower Bounds on Interest Rates"

Answer 30

* There is a limit on the central bank’s options: it must set a nominal rate of zero or higher. * A negative nominal interest rate is impossible. * problem can arise if an adverse expenditure shock occurs, causing a recession. * To end the recession, the central bank must reduce the real interest rate, and the _lower bound may get in the way._ (because the interest rate is already zero).

Question 31

what is the Role of the Deflation in a liquidity trap?

Answer 31

* If an economy enters a liquidity trap, it can be hard to escape. Indeed, the economy can fall into a vicious circle in which the liquidity trap and deflation reinforce one another. * In a liquidity trap, a high real interest rate keeps the economy in a recession. * The recession reduces inflation through the Phillips curve; even if inflation is positive initially, it may fall below zero. * With the nominal interest rate stuck at zero and inflation falling, the real interest rate rises. * The higher real interest rate worsens the recession, which pushes inflation down further, and so on. * Output and inflation can spiral downward.

Question 32

Is there a escape from a liquidity trap ?

Answer 32

According to some economist: 1. Reducing Long-Term InterestRates 2. Raising Expected Inflation 3. Using Fiscal Policy

Question 33

How do you escape a liquidity trap by reducing Long-Term Interest Rates?

Answer 33

* The central bank can reduce long-term rates by reducing either **_expected short rates_** or **_term premiums_**

Question 34

the expectations theory of the term structure of interest rates (graph)(formula)

Answer 34

Question 35

How the Fed escape (at least tried) the liquidity trap by reducing Long-Term Interest Rates? (2008-2010)(expected interest rates)

Answer 35

the Federal Reserve tried to do both: 1. Influence expected interest rates: * The Fed sought to influence expected interest rates through announcements. ​ * During 2009 and 2010, as the Federal Open Market Committee maintained a target range of 0 to 0.25 percent for the federal funds rate, it repeatedly _signaled an intention to keep its **target low**_. * A typical announcement occurred on August 10, 2010, when the FOMC said that economic conditions “are likely to warrant exceptionally _low levels of the federal funds rate for an **extended period.**”_ * The “**_extended period”_** language was meant to _drive down expected future interest rates in the equation for long-term rates_.

Question 36

How the Fed escape (at least tried) the liquidity trap by reducing Long-Term Interest Rates? (2008-2010)(**term premiums)**

Answer 36

the Federal Reserve tried to do both: 1. Influence the term premiums: * by shifting the **composition of its open-market operations** * it **_increased_ its** **purchases of _long-term_ _bonds_** and bought relatively _**few** **short-term bonds**_ * By raising the demand for **long-term bonds**, the Fed hoped to **raise their prices** relative to those of short-term bonds and thereby reduce their yields to maturity * It reduces long-term interest rates for a given path of short-term rates; in other words, it **reduces term premiums.**

Question 37

How do you escape a liquidity trap by Raising Expected Inflation?

Answer 37

* central bank facing a liquidity trap should announce that it plans to increase inflation in the future. * If the public believes that the central bank eventually will raise inflation, then expected inflation rises. * The efficacy of this tactic is unclear, partly because the Federal Reserve has not tried it.

Question 38

How do you escape a liquidity trap by Using Fiscal Policy?

Answer 38

1. By using **expansionary fiscal policy:** * An increase in government spending or a tax cut shifts out the AE curve, raising output at the current real interest rate * If an inward shift of the curve has produced a liquidity trap, a fiscal expansion can reverse this shift. * In addition, if deflation is occurring, fiscal policy can cause an output boom that pushes inflation above zero. * A disadvantage of fiscal expansion is that it increases the level of government debt. * Keynes, who pointed out the problem of the liquidity trap, also suggested this.