ECON 303 Midterm 2 Chapters covered 5 6 7 10 Chapter 5 Inflation Its Causes Effects and Social Costs Inflation is the overall increase in price Rate of Inflation is the percentage change in the overall level of prices Hyperinflation is episodes of extraordinarily high inflation Classical theory of the causes effects and social costs of inflation assumes that prices are flexible Prices are sticky in the short run Prices are flexible in the long run The quantity of money determines the price level and that the rate of growth in the quantity of money determines the rate of inflation Inflation Tax is the revenue that governments can raise by printing money 5 1 The Quantity Theory of Money Quantity theory of money David Hume Quantity equation M V P T T is the number of times in a year that goods or services are exchanged for money P is the price of a typical transaction the number of dollars exchanged M is the quantity of money V is called the transaction velocity of money which measures the rate at which money circulates in the economy Quantity equation M V P Y In this equation V is called the income velocity of money M P Is called real money balances this measures the purchasing power of the stock of money Money demand function is an equation that shows the determinants of the quantity of real money d balances people wish to hold M kY P M d M 1 1 thus M PY which can be written as MV PY where V P P k k Quantity theory of money is a theory about the effects of money 1 The factors of production and the production function determine the level of output Y 2 The money supply M set by the central bank determines the nominal value of output PY 3 The price level P is then the ratio of the nominal value of output PY to the level of output Y The productive capability of the economy determines real GDP The quantity of money determines nominal GDP The GDP deflator is the ratio of nominal GDP to real GDP The quantity equation written in percentage change form is Change M Change V Change P Change Y 5 2 Seigniorage The Revenue From Printing Money Growth in the money supply causes inflation A government can finance its spending in three ways 1 It can raise revenue through taxes such as personal and corporate income taxes 2 It can borrow from the public by selling government bonds 3 It can print money Seigniorage is the revenue raised by the printing of money Not worth a continental means that the item in question had little real value 5 3 Inflation and Interest Rates Nominal Interest Rate is the interest rate that the bank pays Real Interest Rate is the increase in purchasing power r i r is the real interest rate i is the nominal interest rate is the rate of inflation Fisher Equation Irving Fisher i r Nominal interest rate can change because 1 The real interest rate changes 2 The inflation rate changes The Fisher effect is the one for one relation between the inflation rate and the nominal interest rate i E ex post real interest rate is the real interest rate that is actually realized i The fisher effect can be written as i r E 5 4 The Nominal Interest Rate and the Demand for Money The quantity theory is based on a simple money demand function it assumes that the demand for real money balances is proportional to income The nominal interest rate is the opportunity cost of holding money it is what you give up by holding money rather than bonds d General money demand function is M L i Y P Money Supply Price Level Inflation Rate Nominal Interest Rate Money Demand 5 5 The Social Costs of Inflation Purchasing power of labor the real wage depends on the marginal productivity of labor Costs of expected inflation 1 Shoeleather cost of inflation is the inconvenience of reducing money holding 2 Menu cost is when high inflation induces firms to change their posted prices more often 3 When inflation induces variability in relative prices it leads to microeconomic inefficiencies in the allocation of resources 4 Tax laws do not take into account the effects of inflation inflation distorts how taxes are levied 5 The inconvenience of living in a world with a changing price level Costs of unexpected inflation 1 It arbitrarily redistributes wealth among individuals 2 Hurts individuals on fixed pensions The more variable the rate of inflation the greater the uncertainty that both debtors and creditors face One possible benefit of inflation is that it improves the functioning of labor markets by allowing real wages to reach equilibrium levels without cuts in nominal wages 5 6 Hyperinflation Hyperinflation is often defined as inflation that exceeds 50 percent per month 1 2 3 4 5 Hyperinflation makes the economy run less efficiently Nominal business practices are impossible Relative prices do not do a good job of reflecting true scarcity during hyperinflations Tax systems are distorted by hyperinflation Over time money loses its role as a store of value unit of account and medium of exchange Hyperinflation is caused by excessive growth in the supply of money Most hyperinflations begin when the government has inadequate tax revenue to pay for its spending 5 7 Conclusion The Classical Dichotomy Real Variables are variables measured in physical units such as quantities and relative prices Nominal Variables are variables expressed in terms of money such as price level the inflation rate and the dollar wage a person earns Classical Dichotomy is the theoretical separation of real and nominal variables Monetary Neutrality is the irrelevance of money for real variables Chapter 6 The Open Economy An open economy is one that exports goods and services abroad imports goods and services from abroad and borrows and lends in the world financial markets The flow of goods and services across national borders is always matched by an equivalent flow of funds to finance capital accumulation Protectionist trade policies are policies designed to protect domestic industries from foreign competition 6 1 The International Flows of Capital and Goods The key difference between open and closed economies is that in an open economy a country s spending in any given year need not equal its output of goods and services The expenditures on an open economy s output Y can be divided into four components d C consumption of domestic goods services d I investment domestic goods services d G government purchases of domestic goods services X exports of domestic goods services In an open economy domestic spending need not equal the output of goods and