Money growth and inflation Flashcards
(27 cards)
Define inflation
Increase in overall price levels
Define deflation
Decrease in overall price levels
Define hyperinflation
Extraordinarily high rates of inflation
Define the value of money
- 1/P where P is the current price levels
- essentially the quantity of goods you can buy with £1
Explain money supply in terms of determining inflation
- determined by central banks
- we treat the supply curve as vertical and as a policy by CB
Explain money demand in terms of inflation
- determined by the amount of wealth people want to hold as money
- depends on the average price level (P)
- higher P means lower value of money which increases demand
What effect does an increase in money supply have on the equilibrium
- it shifts the supply curve rightwards
- this increases demand which increases price level and reduces value of money
What is the quantity theory of money
- the quantity of money available determines the price level
- growth rate in quantity of money determines inflation rate
What are nominal variables
- variables measured in monetary units
- currency prices
What are real variables
- variables measured in physical units
- quantities, real wages, real interest rate
Explain the classical dichotomy
- theoretical separation of real and nominal variables
- developments in the monetary system will only influence nominal variables
- changes in the money supply do not affect real variables in the long run
What is the quantity of money identity
M x V = P x Y
M - quantity of money
P - price level
Y - output of goods
V - velocity of money
where PxY is nominal GDP
Define velocity of money
- the rate at which money changes hands within the economy
- empirically fairly constant
How does classical dichotomy relate to the quantity of money identity (PxY = VxM)
Since V stays constant and Y is the real value of output, it is not affected by nominal values such as money supply; therefore, a money supply increase will cause changes in P.
What is the real interest rate
Nominal interest rate - inflation rate
What is the Fisher effect
- ‘there is a one-for-one adjustment of nominal interest rate to inflation rate with increases in the rate of money growth’
- this does not hold up short run
Why does the Fisher effect work?
Since:
real interest rate + inflation rate = nominal interest rate
And due to the classical dichotomy the real rate is not influenced by nominal factors. Therefore there must be a correlation between an increase in inflation rate and an increase in nominal interest rate.
What is inflation tax
Revenue the government raises by issuing money, rather than raising taxes or selling bonds. This is a tax on everyone who holds money as the value of money decreases.
How does inflation tax benefit the government
- the government is able to spend the newly issued money before it loses value
- it can reduce the burden of debt as the money is ‘less valuable’
What is the inflation fallacy
- the idea that inflation ‘robs people of their purchasing power’
- in reality nominal wages should also rise alongside the prices
Name costs of inflation
- menu costs
- shoeleather costs
- market economies & misallocation
Explain menu costs
Restaurants changing the prices of their goods have to physically buy new menus
Explain market economies and misallocation
Since prices change, it may create confusion within investors buying too little or too much of an item
Explain shoeleather costs
Since cash is losing value and earning no interests, people want to avoid having it. This results in frequent, small trips to the bank where you must have transaction fees.
