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 LectureThe Inflation Tax- When tax inadequate and ability to borrow is limited, you may print money to pay for itsspendingo Most hyperinflations start this way- Revenue from printing money is an inflation taxo Inflation tax- printing money causes inflation, which is like a tax on everyone whoholds money Mostly affects cash, not money in stocksThe 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, soreal interest rate FIGURE OUT WHAT GOES HERECosts of Inflation- Inflation fallacy- most people think inflation erodes real incomeo 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 holdingso Includes time and transaction costs of more frequent bank withdrawals- Menu costs- costs of changing priceso Printing new menus, mailing new catalogs, etc- Misallocation of resources from relative-price variabilityo 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 incomeo Taxes based on nominal incomeo 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 mucho Lower-than-expected inflation transfers purchasing power from debtors to creditorso These redistributions frequent when inflation is highAggregate 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