Lecture 3 - Inflation Flashcards
(25 cards)
What is inflation?
The percentage change in the overall price level: π_t = 100% × (P_t+1 - P_t)/P_t. Target rate is ~2% in most advanced economies.
What is hyperinflation?
Extremely high inflation (>500% per year), often caused by excessive money printing to fund government deficits.
What are the three main measures of money supply?
- Monetary base (MB): Currency + bank reserves. 2. M1: Currency + demand deposits. 3. M2: M1 + savings deposits.
What is the Quantity Equation?
M_t × V_t = P_t × Y_t (Money supply × Velocity = Price level × Real GDP). An identity that must always hold.
What does the Quantity Theory of Money state about inflation?
Long-run inflation (π) equals money growth rate (g_M) minus real GDP growth rate (g_Y): π = g_M - g_Y.
What is the classical dichotomy?
In the long run, real variables (Y, R) are determined separately from nominal variables (P, M). Money is neutral in the long run.
What is the Fisher equation?
i ≈ R + π (Nominal interest rate = Real interest rate + Inflation rate). Explains how inflation affects interest rates.
What happens when real interest rates are negative?
Borrowers benefit as they repay loans with less valuable money. Savers/lenders lose purchasing power.
What causes a wage-price spiral?
Workers demand higher wages → firms raise prices → workers demand further wage increases, creating inflationary feedback.
What is seigniorage/inflation tax?
Revenue government earns by printing money. Paid by currency holders via reduced purchasing power.
What are menu costs?
Costs firms incur to frequently adjust prices during high inflation. Leads to inefficient resource allocation.
How does inflation create fiscal drag?
Tax brackets based on nominal incomes push taxpayers into higher rates without real income gains.
What distinguishes M1 from M2 money supply?
M1 includes currency + checking accounts. M2 adds savings accounts and money market funds.
Why is central bank independence important?
Prevents governments from using monetary policy for short-term political gain, reducing inflation risks.
What happens during hyperinflation?
Money loses value rapidly (>50% monthly). Often caused by deficit financing via money printing.
How do sticky prices affect the classical dichotomy?
In short run, prices adjust slowly → changes in M can affect real GDP (Y). Long-run neutrality still holds.
What is the velocity of money (V)?
Average times a dollar is spent annually. V = (P × Y)/M. Often stable long-term but volatile during crises.
How to adjust nominal values for inflation?
Use CPI: Real value = Nominal × (CPI_base/CPI_current). E.g., $70k in 1970 ≈ $527k in 2022 dollars.
What are the costs of unexpected inflation?
- Redistributes wealth (lenders → borrowers). 2. Tax distortions. 3. Price volatility. 4. Menu costs.
How to calculate inflation from money growth?
π* = g_M - g_Y (if V is constant). E.g., g_M=5%, g_Y=2% → π*=3%.
What is the role of CPI in measuring inflation?
Tracks price changes of a consumer basket. Core CPI excludes volatile items (food/energy).
Why might velocity (V) decline?
During recessions (e.g., COVID), people hold cash rather than spend, reducing V temporarily.
What causes short-run deviations from the Fisher equation?
Sticky inflation expectations → nominal rates may not adjust immediately to π changes.
How do inflation expectations affect actual inflation?
Self-fulfilling: If firms/workers expect high π, they raise prices/wages → actual π increases.
