PowerPoint PresentationSlide 2Slide 3Slide 4Slide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Slide 14Slide 15Slide 16Slide 17Slide 18Slide 19Slide 20Slide 21Slide 22Slide 23Slide 24Slide 25Slide 26Slide 27Chapter Five1CHAPTER 5Inflation: Its Causes, Effects, and Social CostsA PowerPointTutorialTo Accompany MACROECONOMICS, 8th EditionN. Gregory Mankiw Tutorial written by:Mannig J. SimidianB.A. in Economics with Distinction, Duke University M.P.A., Harvard University Kennedy School of GovernmentM.B.A., Massachusetts Institute of Technology (MIT) Sloan School of ManagementChapter FiveHyperinflation is defined as inflation that exceeds 50 percent per month, which is just over 1percent a day.Costs such as shoe-leather and menu costs are much worse with hyperinflation—and tax systems are grossly distorted. Eventually, when costs become too great with hyperinflation, the money loses its role as store of value, unit of account and medium of exchange. Bartering or using commodity money becomes prevalent.Chapter FiveThe quantity equation is an identity: the definitions of the four variables make it true. If one variable changes, one or more of the others must also change to maintain the identity. The quantity equation we will use from now on is the money supply (M) times the velocity of money (V) which equals price (P) times the number of transactions (T):Money  Velocity = Price  Transactions M  V = P  TV in the quantity equation is called the transactions velocity of money. This tells us the number of times a dollar bill changes hands in a given period of time.Chapter FiveTransactions and output are related, because the more theeconomy produces, the more goods are bought and sold.If Y denotes the amount of output and P denotes the price of oneunit of output, then the dollar value of output is PY. Weencountered measures for these variables when we discussedthe national income accounts.Money  Velocity = Price  Output M  V = P  YThis version of the quantity equation is called the incomevelocity of money, which tells us the number of times a dollarbill enters someone’s income in a given time.Chapter FiveLet’s now express the quantity of money in terms of the quantity ofgoods and services it can buy. This amount, M/P is called real money balances. Real money balances measure the purchasing power of the stock of money.A money demand function is an equation that shows the determinants of real money balances people wish to hold. Here is a simple money demand function:where k is a constant that tells us how much money people want to hold for every dollar they earn. This equation states that the quantity of real money balances demanded is proportional to real income.(M/P)d = k YChapter FiveThe money demand function is like the demand function for a particular good. Here the “good” is the convenience of holding real money balances. Higher income leads to a greater demand for real money balances. The money demand equation offers another way to view the quantity equation (MV= PY) where V = 1/k.This shows the link between the demand for money and the velocityof money. When people hold a lot of money for each dollar of income (k is large), money changes hands infrequently (V is small).Conversely, when people want to hold only a little money (k is small), money changes hands frequently (V is large). In other words, the money demand parameter k and the velocity of money V are opposite sides of the same coin.Chapter FiveThe quantity equation can be viewed as a definition: it defines velocity V as the ratio of nominal GDP, PY, to the quantity of money M. But, if we make the assumption that the velocity of money is constant, then the quantity equation MV = PY becomes a useful theory of the effects of money. The bar over the V means that velocity is fixed. The quantity equation can be viewed as a definition: it defines velocity V as the ratio of nominal GDP, PY, to the quantity of money M. But, if we make the assumption that the velocity of money is constant, then the quantity equation MV = PY becomes a useful theory of the effects of money. The bar over the V means that velocity is fixed. So, let’s hold it constant! Remembera change in the quantity of money causesa proportional change in nominal GDP.MV = PYChapter FiveThree building blocks that determine the economy’s overall level of prices:The factors of production and the production function determinethe level of output Y.The money supply determines the nominal value of output, PY.This follows from the quantity equation and the assumption thatthe velocity of money is fixed.The price level P is then the ratio of the nominal value of output,PY, to the level of output Y.Chapter FiveIn other words, if Y is fixed (from Chapter 3) because it dependson the growth in the factors of production and on technological progress, and we just made the assumption that velocity is constant,or in percentage change form: MV = PY% Change in M + % Change in V = % Change in P + % Change in Y% Change in M + % Change in V = % Change in P + % Change in Yif V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P.The quantity theory of money states that the central bank, whichcontrols the money supply, has the ultimate control over the inflation rate. If the central bank keeps the money supply stable,the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.Chapter FiveThe revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.Chapter FiveChapter FiveEconomists call the interest rate that the bank pays the Nominal interest rate and the increase in your purchasing power thereal interest rate.This shows the relationship between the nominal interest rateand the rate of inflation, where r is real interest rate, i is the nominal interest rate and is the rate of