topic 5

Question 1

Define inflation?

Answer 1

A sustained increase in the GPL of G&S in an economy over a period of time

Question 2

What is CPI?

Answer 2

the rate at which prices of G&S bought by households rise & fall

Question 3

Main UK measures of inflation? (5)

Answer 3

CPI, PPI, HPI, index of private housing rental prices and construction output price indices

Question 4

What is the Quantity Theory of Money(QToM)?

Answer 4

a simple theory linking inflation rate to the growth rate of the money supply

Question 5

What is the velocity of money?

Answer 5

rate at which money circulates = the avg number of times a $bill changes hands in a given time period

Question 6

Price level = ?

Answer 6

nGDP/rGDP

Question 7

See notes

Answer 7

bit that gives inflation equation

Question 8

Growth rate of a product = ?

Answer 8

Sum of growth rates

Question 9

What does the QToM predict?

Answer 9

A one-for-one relation between change in money growth rate and change in inflation rate

Question 10

What does the quantity theory of money imply? (2)

Answer 10

1) Countries with higher money growth should have higher inflation rates
2) The LR trend in a country’s inflation rate should be similar to the LR money growth rate.

Question 11

See data in slides and notes on confronting QToM with data

Answer 11

now

Question 12

Why in the short run do we observe a negative relationship between inflation and money supply growth?

Answer 12

if expected inflation rises, the CB may cut money supply to keep it steady & vice versa

Question 13

What is Seignorage?

Answer 13

the revenue raised from printing money

Question 14

Why is seignorage bad?

Answer 14

it causes inflation, and inflation acts like a tax on people who hold money

Question 15

What is the relationship between inflation and i, and why?

Answer 15

since r is determined exgoenously by S=I, via the fisher equation there is a 1 for 1 relationship between inflation and nominal interest rate

Question 16

See notes and slides for data

Answer 16

now

Question 17

What is E(pi)?

Answer 17

expected inflation rate

Question 18

What is an ex ante real interest rate?

Answer 18

i-E(pi) - the real interest rate people expect when they buy a bond or take out a loan

Question 19

What is an ex post real interest rate?

Answer 19

i-pi - the real interest rate actually realised

Question 20

Note

Answer 20

In QToM M/P only depends on Y, however in reality it also depends negatively on i, because i is the opportunity cost of holding money.

Question 21

When is equilibrium in money market?

Answer 21

(M/P) = L(r+E(pi),Y)

ie supply of RMB = demand for RMB

Question 22

How is M determined in the LR?

Answer 22

exogenously (by the Fed)

Question 23

How is r determined in the LR?

Answer 23

adjusts so S=I

Question 24

How is Y determined in the LR?

Answer 24

Y=F(K,L)

where K, L and Y are all fixed

Question 25

How is P determined in the LR? and note?

Answer 25

Adjusts so M/P=L(i,Y)

If r, Y and E(pi) are all fixed, a change in M causes an equal change in P

Question 26

See notes on expected inflation!!!

Answer 26

now

Question 27

Why is inflation bad?

Answer 27

Common misconception is that is lowers real wage, however this is only in short run when wages are rigid

Question 28

What is the classical view of inflation?

Answer 28

It is just a change in units of measurement

Question 29

5 social costs of expected inflation?

Answer 29

1) Shoeleather costs
2) Menu costs
3) relative price distortions
4) unfair tax treatment
5) general inconvenience

SMURG

Question 30

What are shoeleather costs?

Answer 30

costs and inconveniences of reducing money balances to avoid inflation. ie. high inflation rate means people dont want to hold lots of cash tf lots of trips to the bank to withdraw money

Question 31

What are menu costs?

Answer 31

costs of having to change the prices on menus etc.

Question 32

Explain what is meant by relative price distortions?

Answer 32

eg. firms only issue new catalogue once a year, but inflation changes throughout the year tf microeconomic inefficiencies

Question 33

Explain what is meant by unfair tax treatment?

Answer 33

Some taxes not adjusted for inflation such as capital gains tax (see example)

Question 34

Explain what is meant by general inconvenience?

Answer 34

eg. Inflation makes it hard to compare nominal values from different time periods

Question 35

What are two costs of unexpected inflation?

Answer 35

1) Arbitrary redistribution of purchasing power

2) Increased uncertainty

Question 36

Explain what is meant by arbitrary redistribution of purchasing power?

Answer 36

LT contracts are often estimated based on E(pi) tf if it is wrong some may win while others may lose

Question 37

What is meant by increased uncertainty?

Answer 37

When inflation is high it is more unpredictable tf larger differences between inflation and expected inflation tf arbitrary redistribution of purchasing power is more likely tf increased uncertainty tf risk averse people become worse off

Question 38

Benefit of inflation?

Answer 38

Better functioning labour markets - nominal wages are rarely reduced tf hindering labour market clearing tf inflation allows real wages to reach equilibrium without nominal wage cuts

Question 39

Define hyperinflation?

Answer 39

inflation greater than or equal to 50% a month

Question 40

Cause of hyperinflation?

Answer 40

Excessive money growth (printing too much money)

Question 41

Solution to hyperinflation?

Answer 41

Stop printing money but this can then lead to fiscal constraints

Question 42

What does the classical dichotomy argue?

Answer 42

that although nominal and real variables are related, nominal variables do not affect real variables

Question 43

See notes below classical dichotomy

Answer 43

now

Question 44

What does the classical dichotomy lead to?

Answer 44

Neutrality of money = changes in the money supply do not affect real variables tf in LR money is neutral

Question 45

Explain an example of unfair tax treatment?

Answer 45

Buy £10K worth of stock 1st Jan
Sell if for £11K 31st December
But 10% inflation tf nominal gain=£1K but real gain =0
Still have to pay taxes on £1000 nominal gain!

(Capital gains tax)