Lecture 14 - Money Market and Inflation in the Long Run Flashcards Preview

Macroeconomics (Economics Cambridge Part I) > Lecture 14 - Money Market and Inflation in the Long Run > Flashcards

Flashcards in Lecture 14 - Money Market and Inflation in the Long Run Deck (21)
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1
Q

What is the equilibrium in the money market? How are all the variables determined?

A
  • supply of real money balances = M/P
  • real money demand = L(r + (π subscript e), Y)
  • equilibrium when supply = demand
  • M: exogenous, r: adjusts to make S = I, Y = F(K,L), P: endogenous, adjusts to bring M/P = L(i,Y)
2
Q

In an ideal run, over the long-run, across large populations, what would the relationship between (π subscript e) and π be?

A
  • π subscript e = π
  • expected inflation = actual inflation
3
Q

Why in the short-medium run does the inflation rate not equal the expected inflation rate?

A
  • misinformation
  • may change when people get new information (e.g. about prices)
  • pessimism/optimism
  • inattention
4
Q

For given values r, Y and M, how does P respond to changes in (π subscript e)?

A

increase in (π subscript e) –> i increases (Fisher effect) –> demand for real money decreases –> P increases

5
Q

For given values of r, Y and (π subscript e), what does a change in M cause P to do?

A
  • Channel 1:
  • a change in M causes P to change by the same percentage just like in the Quantity Theory of Money
  • Channel 2:
  • by QT/Fisher effect, M ↑ means (π subscript e) ↑, and i ↑, and P ↑
  • overall effect, P ↑↑
  • price level today depends on both current and future monetary policy (through inflation expectations)
6
Q

Show the cyclical nature of money, prices and interest rates?

A
  • money supply and money demand determine prices
  • prices determine the inflation rate
  • the inflation rate determines the nominal interest rate (through the Fisher effect)
  • the nominal interest rate affects the money supply and demand
7
Q

What is the classical view of inflation?

A

a change in the price level is merely a change in the units of measurement, in other words, changes in inflation have no real effects

8
Q

What are the 2 categories for the social costs of inflation?

A
  • costs when inflation in expected
  • additional costs when inflation is different than people had expected
9
Q

Define shoe-leather costs

A

the costs and inconveniences of reducing money balances to avoid the inflation tax

10
Q

The quantity theory of money assumes constant velocity, why may this mean that the quantitative theory is not suitable for the short-run?

A
  • high inflation leads to high shoe leather costs, leads to less demand for money, which leads to higher velocity
  • velocity may vary in the short run
  • meant to be constant, quantity theory not suitable for the short run
11
Q

Define menu costs, give an example

A
  • the costs of changing prices
  • cost of printing new menus
12
Q

What is the relationship between inflation and menu costs?

A

the higher the inflation, the more frequently firms must change their prices and incur these costs

13
Q

Explain how menu costs can lead to relative price distortions, and thus be a cost of expected inflation

A
  • firms facing menu costs change prices infrequently
  • example: suppose a firm issues new catalogue each January. As the general price level rises throughout the year, the firm’s relative price will fall
  • different firms change their prices at different times, leading to relative price distortions
  • which cause microeconomic inefficiencies in the allocation of resources
14
Q

Explain how unfair tax treatment may be a cost of expected inflation

A
  • some taxes are not adjusted to account for inflation, such as the capital gains tax
  • for example:
  • Jan 1: you bought £10,000 worth of a stock
  • Dec 31: you sold the stock for £11,000, so your nominal capital gain was £1000 (10%).
  • Suppose π = 10% during the year. Your real capital gain is £0.
  • But the govt requires you to pay taxes on your
    £1000 nominal gain!
15
Q

Explain how inflation may complicate long-range financial planning

A
  • inflation makes it harder to compare nominal values from different time periods
  • this complicates long-range financial
    planning
16
Q

Explain 2 costs of unexpected inflation

A
  • arbitrary redistribution of wealth and purchasing power (e.g. pensioners with fixed pensions get hurt)
  • increased uncertainty: π turns out different from πe more often, and the differences tend to be larger – makes risk averse people worse off (distorts their inter-temporal decisions)
17
Q

List 3 costs of expected inflation

A
  • menu costs
  • complicates long-range financial planning
  • causes unfair tax treatments
18
Q

Give one benefit of inflation

A
  • nominal wages are rarely reduced, even when the equilibrium real wage falls
  • inflation allows the real wages to reach equilibrium levels without nominal wage cuts
  • therefore, moderate inflation improves the functioning of labour markets
19
Q

Define hyperinflation

A

π > 50% per month

20
Q

What is the government budget constraint?

A
  • G = T + ΔB + ΔM
  • G = government funds
  • T = tax revenue
  • ΔB = borrowing
  • ΔM = changes in the stock of money
21
Q

What is meant by seignorage and the inflation tax? Who is the inflation tax paid paid?

A
  • names for the revenue that the government obtains from printing more money (ΔM)
  • the inflation tax is paid by people holding currency