Macroeconomics Exam 2: Chapter 17 Money Growth and Inflation

The inflation rate is measured as the percentage change in a price index.

The quantity theory of money can explain hyperinflations but not moderate inflation

As the price level falls, the value of money falls.

If P represents the price of goods and services measured in money, then 1/P is the value of money measured in terms of goods and services.

The price level is determined by the supply of, and demand for, money.

When the value of money is on the vertical axis, the money supply curve slopes upward because an increase in the value of money induces banks to create more money.

When the value of money is on the vertical axis, the money supply curve is vertical and shifts right if the Federal Reserve buys bonds.

The money demand curve shifts to the left when the Fed buys government bonds.

The money demand curve is downward sloping because as the value of money falls people desire to hold a larger quantity of money.

If money demand shifts right, the price level falls.

If the quantity of money supplied is greater than the quantity demanded, then prices should fall.

If the Fed increases the money supply, the equilibrium value of money decreases and the equilibrium price level increases.

If the Fed conducts open market sales (selling bonds in the open market), the equilibrium value of money decreases and the equilibrium price level increases.

Nominal GDP measures output of final goods and services in physical terms.

Real GDP measures output of final goods and services in physical units.

The classical dichotomy is useful for analyzing the economy because in the long run nominal variables are heavily influenced by developments in the monetary system, and real variables are not.

The irrelevance of monetary changes for real variables is called monetary neutrality. Most economists accept monetary neutrality as a good description of the economy in the long run, but not the short run.

Monetary neutrality means that while real variables may change in response to changes in the money supply, nominal variables do not.

The quantity equation is M x V = P x Y.

The quantity theory of money implies that if output and velocity are constant, then a 50 percent increase in the money supply would lead to less than a 50 percent increase in the price level.

If the money supply increased by 10% and at the same time real GDP increased by 10%, then according to the quantity equation there would be no change in the price level.

According to the Fisher effect, if inflation rises then the nominal interest rate rises.

If the real interest rate is 5% and the inflation rate is 3%, then the nominal interest rate is 8%.

Inflation induces people to spend more resources maintaining lower money holdings. The costs of doing this are called shoeleather costs.

Shoeleather costs and menu costs are both costs of anticipated inflation.

For a given real interest rate, an increase in the inflation rate reduces the after‐tax real interest rate.

Suppose the nominal interest rate is 5 percent, the tax rate on interest income is 30 percent, and the after‐tax real interest rate is 2.1 percent. Then the inflation rate is 2 percent. (Suppose you have $100 in your bank account to solve this question if you need.)

A person received 4% nominal interest. The inflation rate was ‐2% and the tax rate was 25%. This person received an after‐tax real interest rate of 5%. (Suppose you have $100 in your bank account to solve this question if you need.)

Inflation is costly only if it is unanticipated.

If the Fed were to unexpectedly increase the money supply, creditors would gain at the expense of debtors.

Quantity Theory of Money

Price Level (P)

Value of Money

If price level increases...

Money Supply

Money Demand

Higher Money Demand =

Equilibrium Quantity of Money and Price Level

Equilibrium Price Level (Peqm):

Classical Dichotomy

Nominal Variables

Real Variables

Quantity Equation

M x V = P x Y Breakdown

Velocity of Money

Velocity

Money supply is controlled by the Fed.

The real GDP (Y) is real variable. Money neutrality assures that Y is not affected by changes in M.

The real GDP (Y) changes due to a change in technology or factors of production, price also changes.

The Fisher Effect

The Fisher Effect: As money supply changes...

Costs of Inflation

Shoeleather Costs

Menu Costs

Misallocation of Resources from relative‐price variability

Inflation‐induced Tax Distortion

Costs of Unexpected Inflation

Arbitrary redistributions of wealth