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UIUC ECON 303 - ECON 303 Midterm 2 Study Guide

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ECON 303 Midterm 2Chapters covered:5, 6, 7, 10Chapter 5 Inflation: Its Causes, Effects, and Social CostsInflation is the overall increase in priceRate of Inflation is the percentage change in the overall level of pricesHyperinflation is episodes of extraordinarily high inflationClassical theory of the causes, effects, and social costs of inflation assumes that prices are flexiblePrices are sticky in the short runPrices are flexible in the long runThe quantity of money determines the price level and that the rate of growth in the quantity of money determines the rate of inflationInflation Tax is the revenue that governments can raise by printing money5-1 The Quantity Theory of MoneyQuantity theory of money – David Hume Quantity equation: M × V =P ×TT is the number of times in a year that goods or services are exchanged for moneyP is the price of a typical transaction – the number of dollars exchangedM is the quantity of moneyV is called the transaction velocity of money, which measures the rate at which money circulates in the economyQuantity equation: M × V =P ×YIn this equation V is called the income velocity of moneyMP Is called real money balances, this measures the purchasing power of the stock of moneyMoney demand function is an equation that shows the determinants of the quantity of real money balances people wish to hold. (MP)d=kY, (MP)d=(MP)thus M(1k)=PY , whichcan be written as MV =PY ,where V =(1k)Quantity theory of money is a theory about the effects of money1. The factors of production and the production function determine the level of output Y2. The money supply M set by the central bank determines the nominal value of output PY3. The price level P is then the ratio of the nominal value of output PY to the level of output YThe productive capability of the economy determines real GDPThe quantity of money determines nominal GDPThe GDP deflator is the ratio of nominal GDP to real GDPThe quantity equation written in percentage-change form, is% Change∈M +% Change∈V =% Change∈P+% Change∈Y5-2 Seigniorage: The Revenue From Printing MoneyGrowth in the money supply causes inflationA government can finance its spending in three ways:1. It can raise revenue through taxes, such as personal and corporate income taxes2. It can borrow from the public by selling government bonds3. It can print moneySeigniorage is the revenue raised by the printing of money“Not worth a continental” means that the item in question had little real value5-3 Inflation and Interest RatesNominal Interest Rate is the interest rate that the bank paysReal Interest Rate is the increase in purchasing powerr=i−πr is the real interest ratei is the nominal interest rate π is the rate of inflationFisher Equation(Irving Fisher)i=r +πNominal interest rate can change because 1. The real interest rate changes2. The inflation rate changesThe Fisher effect is the one-for-one relation between the inflation rate and the nominal interest ratei−Eπex post real interest rate is the real interest rate that is actually realizedi−πThe fisher effect can be written as i=r +Eπ5-4 The Nominal Interest Rate and the Demand for MoneyThe quantity theory is based on a simple money demand function: it assumes that the demand for real money balances is proportional to incomeThe nominal interest rate is the opportunity cost of holding money: it is what you give up by holding money rather than bondsGeneral money demand function is (MP)d=L(i ,Y) 5-5 The Social Costs of InflationPurchasing 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 holding2. Menu cost is when high inflation induces firms to change their posted prices more often3. When inflation induces variability in relative prices it leads to microeconomic inefficiencies in theallocation of resources4. 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 levelCosts of unexpected inflation:1. It arbitrarily redistributes wealth among individuals2. Hurts individuals on fixed pensions*The more variable the rate of inflation, the greater the uncertainty that both debtors and creditors face Money SupplyPrice LevelInflation RateNominal InterestRateMoney DemandOne 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 wages5-6 HyperinflationHyperinflation is often defined as inflation that exceeds 50 percent per month1. Hyperinflation makes the economy run less efficiently2. Nominal business practices are impossible3. Relative prices do not do a good job of reflecting true scarcity during hyperinflations4. Tax systems are distorted by hyperinflation 5. Over time money loses its role as a store of value, unit of account, and medium of exchangeHyperinflation is caused by excessive growth in the supply of money Most hyperinflations begin when the government has inadequate tax revenue to pay for its spending5-7 Conclusion: The Classical DichotomyReal Variables are variables measured in physical units, such as quantities and relative pricesNominal Variables are variables expressed in terms of money, such as price level, the inflation rate, and the dollar wage a person earnsClassical Dichotomy is the theoretical separation of real and nominal variablesMonetary Neutrality is the irrelevance of money for real variablesChapter 6: The Open EconomyAn 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 accumulationProtectionist trade policies are policies designed to protect domestic industries from foreign competition6-1 The International Flows of Capital and GoodsThe 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 servicesThe expenditures on an open economy’s output Y can be divided into four components:Cd, consumptionof domestic goods∧servicesId,investment ∈domestic goods∧servicesGd, government purchases of domestic goods∧servicesX , exports of domestic goods∧servicesIn an open economy,


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UIUC ECON 303 - ECON 303 Midterm 2 Study Guide

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