EC 111 1st Edition Lecture 15PREVIOUS LECTUREI. IntroductionII. The Value of MoneyIII. Money SupplyIV. Money DemandV. The Money Supply DiagramVI. A Brief Look at the Adjustment ProcessVII. Real vs Nominal VariablesVIII. Real vs Nominal WageIX. Classical DichotomyX. The Neutrality of MoneyXI. The Velocity of MoneyXII. The Quantity EquationCURRENT LECTUREI. Quantity Theory in Five StepsII. HyperinflationIII. The Inflation TaxIV. The Fisher EffectV. The Cost of InflationQUANTITY THEORY IN FIVE STEPS- Start with the quantity equation: M*V=P*Y1) V is stable2) So, a change in M causes nominal GDP (P*Y) to change by the same percentage3) A change in M does not affect Y:a. Money is neutral b. Y is determined by technology and resurces4) So, P changes by same percentage as P*Y and M5) Rapid money supply growth causes rapid inflation- If real GDP (Y) is constant then inflation rate=money growth rate- If real GDP (Y) is growing, then inflation rate is < money growth rate- Bottom line:o Economic growth increases the number of transactionso Some money growth is needed for these extra transactionso Excessive money growth causes inflationThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.HYPERINFLATION- Hyperinflation is generally defined as inflation exceeding 50% per month- Recall one of the 10 Principles of Economicso Prices rise when the government prints too much money- Excessive growth in money supply always causes hyper inflation- Germany had hyperinflation and had to burn all of their currency and start over with a new currencyTHE INFLATION TAX- When tax revenue is inadequate and ability to borrow is limited, government may print money to pay for its spendingo Almost all hyperinflations start this way- Inflation Tax: the revenue from printing moneyo Printing money causes inflation, which is like a tax on everyone who holds moneyo Accounts for < 3% in the USTHE FISHER EFFECT- Nominal Interest Rate = Inflation Rate + Real Interest Rate- In the long run money is neutral, so a change in the money growth rate affects the inflation rate but not the real interest rate- So the nominal interest rate adjusts one-for-one with changes in the inflation rate- This relationship is called the Fisher effect after Irving Fisher who studied it- The Fisher effect: an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate is unchanged. In other words, a 1% increase in inflation causes a 1% increase in the nominal interest rateTHE COST OF INFLATION- The Inflation Fallacy: most people think inflation erodes real incomes or their purchasing power- Inflation is a general increase in prices of things people buy and the things hey sell, so income rises with inflation- In the long run, real incomes are determined by real variables such as human capital, physical capital, technology, and natural resources, not inflation rateo Human capital: education/skills- So, nominal income = real income + inflation- Shoeleather Costs: the resources wasted when inflation encourages people to reduce their money holdingo Includes the time and transactions costs of more frequent bank withdrawlso Much more technology so not as much of a problem- Menu Cost: the cost of changing priceso Printing new menus, mailing new catalogs, and changing price tagso Higher inflation causes more frequent price changes which leads to higher menu costs- Misallocation of Resources from Relative-Price Variablity: Firms don’t all raise prices at the same time, so relative prices can vary…which distorts the allocation of resources- Confusion and Inconvenience: inflation changes the yardstick we used to measure transaction- Complicates long-run planning and the comparison of dollar amounts over time- Tax Distortions: inflation makes nominal incomes grow faster than real incomeso Taxes are based on nominal income and are not adjusted for inflation o Inflation causes people to pay more taxes even when their real incomes don’t increaseInflation raises nominal interest rates (Fisher Effect), but not real interest rates, increases tax savers tax burdens, and lowers the after-tax real interest