Week 7 - Venezuela, Inflation and Aggregate Supply

Question 1

What is the Quantity Theory of Money

Answer 1

The quantity theory of money states that the price level is directly proportional to the nominal money supply

MV = PY
M - nominal money supply
V - velocity of money
P - price level
Y - real output (GDP)

Question 2

What are the Classical theory assumptions of the quantity theory of money (x3)

Answer 2

1. Output (Y) is fixed at its natural level (Y*) full employment output
2. Velocity (V) is constant
3. Prices and wages are flexible - markets always clear

Question 3

Why is Inflation so bad (x3)

Answer 3

1. Shoe leather costs - the negative effects of inflation can be avoided by holding less money, so people will make more frequent trips to the bank to change their savings into cash
2. Menu costs - it is costly for firms to change their prices
3. Misallocation costs - if some businesses find it easier to change their prices than others, then inflation distorts the role of prices in reflecting the relative value of different goods and services

Question 4

Who are the winners and losers of inflation

Answer 4

Inflation benefits borrowers but hurts lenders

Question 5

What is the Fisher equation

Answer 5

The fisher equation shows the relationship between the nominal interest rate (r), the real interest rate (i) and the inflation rate (pi)

1 + i = (1 + r) / (1 + pi)

i = r - pi