ECON 205 1st Edition Lecture 16 Outline of Last Lecture Quantity Theory of Money Value of Money The Quantity Theory of Money Money Demand MD Outline of Current Lecture What are econ fluctuations How does the model of aggregate demand and aggregate supply explain fluctuations What determines shape of AD curve What shifts it Shape of AS curve in short run vs long run Current Lecture The Inflation Tax When tax inadequate and ability to borrow is limited you may print money to pay for its spending o Most hyperinflations start this way Revenue from printing money is an inflation tax o Inflation tax printing money causes inflation which is like a tax on everyone who holds money Mostly affects cash not money in stocks The Fisher Effect Real interest rate determined by savings and investments in the loanable funds market Money supply growth determines inflation rate In long run money is neutral so changes in money growth rate affects the inflation rate but not real interest rate Inflation tax applies to people s holdings of money Fisher Effect an increase in inflation causes an equal increase in nominal interest rate so real interest rate FIGURE OUT WHAT GOES HERE Costs of Inflation Inflation fallacy most people think inflation erodes real income o Inflation is an increase in prices of things people buy and sell i e labor In long run real income is only affected by real variables Shoeleather costs resources wasted when inflation encourages people to reduce their money holdings o Includes time and transaction costs of more frequent bank withdrawals Menu costs costs of changing prices o Printing new menus mailing new catalogs etc Misallocation of resources from relative price variability o Firms don t all increase prices at the same time so relative prices can vary distorting allocation of resources Confusion and inconvenience inflation changes the yardstick we use to measure prices Tax Distortions inflation makes nominal income grow faster than real income o Taxes based on nominal income o Inflation causes people to pay more taxes when their real incomes don t change Arbitrary redistribution of wealth higher than expected inflation transfers purchasing power from creditors to debtors Debtors get to repay their debt with dollars that aren t worth as much o Lower than expected inflation transfers purchasing power from debtors to creditors o These redistributions frequent when inflation is high Aggregate Demand and Aggregate Supply Intro Real GDP grows about 3 per year Recession period of falling real incomes and increase unemployment Depression severe recession Short run economic fluctuations business cycles