Chapter 17 Econ

Rise in the general level of prices of goods and services in an economy over a period of time

1/P how many baskets can we buy with $1 price level of P

P to rise the number of baskets that I can buy with one dollar diminishes

erodes

the quantity of money available determines the price level the growth rate of the quantity of money available determines the inflation rate in the economy

Ms = φB.

expected return risk associated with the asset liquidity of the asset

asset: agents need to choose how much of their wealth to keep as money

liquid, risky, lowest

interest rate (oc of money) income and wealth Payment tech available (ATM, credit cards) Price Level

Md = P x Ld(Y, i)

demand for nominal money balances (M1)

aggregate price level (CPI or GDP deflator)

demand for liquidity

real GDP

nominal interest rate real interest rate +inflation

proportional prices go up 10%, keep 10% more money in their pockets

desired consumption increases- individuals need more money for desired transactions

as the value of money rises, the price level falls The Fed sets MS at some fixed value regardless of P A fall in the value of money, or increase in P, increases the quantity of money demanded P adjust to equate quantity of money demanded with money supply

Then the value of money falls, and P rises Q of money demanded increases

Long Run Logic: 1 The Economy is in equilibrium at A 2 The helicopter comes and drop extra money everywhere 3 Everyone has more money to spend 4 The economy's ability to produce goods and services has not changed: the quantity of goods is fixed 5 Everyone is willing to renounce to more bills than before for the same quantity of goods: the prices of all goods must increase. 6 The increase in MS implies that the price of all goods and services increases at the same time, and then P increases.

measured in monetary units

measured in physical units

the theoretical separation between nominal and real variables can be analyzed separately

proposition that changes in the money supply do not affect real variables

imagine that one foot=6 inches all measured heights are bigger but the actual heigh of everything is the same in the long run we are not taller, but in short run there is confusion as some people may think they are taller

the number of transactions in which the average dollar is used

V = PY/M v is the velocity of money PY = nominal GDP M is the money supply everything bought/all the money used to buy things

the quantitative theory of money

velocity of money is fairly stable over time Real GDP does not change with M (neutrality of money) increase in M will be translated into higher inflation

inflation rate = money growth rate

inflation rate < money growth rate

econ growth increases the number of transactions money growth is needed for these extra transactions excessive money growth causes inflation

neutrality of money: The nominal interest rate adjusts one-for-one with the changes in inflation rate real interest rate = nominal interest rate - inflation rate

Imagine that the government needs money. Ex: It wants to expand the social benefits for the incoming elections The cost of a hundred dollar bill is less than a cent, but it is worth 100 dollars! Just print money and use it! Who pays for that? Inflation reduces the value of money, so everyone who has money is paying for that. In particular, poor people with less access to indexation Inflation is a tax, and it is a regressive one! How to prevent this? Central bank should be independent. Monetary and fiscal policy should not depend on the same people!

Printing money is usually the politically preferred tool to pay for public debts. The Central Bank monetizes some of the government debt. Large budget deficits are typically the underlying cause of hyperinflations. Central Bank independence from fiscal authorities can insulate it from pressure to monetize the public debt

is monthly inflation higher than 50% Mechanism: 1. As more money is printed the money supply increase and the value of money falls 2. Money becomes a hot potato in high inflation countries. It loses value so quickly that people spend it as soon as possible rather than hold it and watch it lose value. 3. Thus velocity then rises 4. The prices increase even faster than the growth rates of money

mot people think inflation erodes real income by the neutrality of money real income is not affected

the resources wasted when inflation encourages people to reduce their money holdings

the costs of changing prices

not all prices raise at the same time, so relative prices can vary in the short run, distorting the allocation of resources

inflation makes nominal income grow faster than real income

inflation changes the yardstick we use to measure transactions

in nominal contracts higher than expected inflation transfer purchasing power from creditors to debtors

Friedman Rule: shoe leather costs of holding money would be minimized by a nominal interest rate close to zero: requires deflation equal to interest rate wages are sticky positive inflation allows to reduce real wages and increase competitiveness

is most consistent over the longer run with the Federal Reserve's mandate for price stability and maximum employment

In the industrialized world inflation is getting very close to zero. Japan experienced deflation from early 90's to 2009. Deflation is considered a problem: Costs of deflation: mirror the costs of inflation (menu costs and relative-price variability) Redistribution of wealth towards creditors and away from debtors. Debtors are often poorer, so this redistribution is particularly painful. Worsens the sticky prices problem. We will see in future lectures that falling prices reduce the aggregate demand and rise unemployment. The belief that goods bought tomorrow will be cheaper than goods bought today chokes consumption.

percentage change in GDP deflator

decreased the discount rate. The discount rate is the interest rate on the loans the Fed makes to other banks. When the Fed decreases the discount rate, banks have a stronger incentive to borrow more money from the Fed since the interest they have to pay back has decreased. This will lead to increased borrowing from the Fed, and the money borrowed will end up in reserves at other banks. This means, as the Fed decreases the discount rate, borrowing increases and reserves increase.

The Fed increases the interest rate on bank deposits held at the Fed. If the Fed increases interest paid on reserves held at the Fed, then banks will be encouraged to hold more reserves at the Fed. This will increase the reserve ratio in the economy, which will decrease the money multiplier.

CPI differences 100 to 105

The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. Because the after-tax real interest rate provides the incentive to save, saving is much less attractive in the economy with high inflation.

Indexing the tax system to take into account the effects of inflation.

true Unexpected changes in prices redistribute wealth among debtors and creditors. Lower than expected inflation makes lenders (creditors) better off at the expense of the borrowers (debtors) because it increases the real value of the debt as the real interest rate is the difference between the nominal interest rate and the inflation rate.