03 14 2013 Vocab Inflation Deflation The increase in the overall level of prices The decrease in the overall level of prices Hyperinflation An extraordinarily high rate of inflation Quantity Theory of Money Nominal Variables Variables measured in monetary units Real Variables Variables measured in physical units Classical Dichotomy The rate at which money changes hands Monetary Neutrality variables Velocity of Money V P x Y M V Velocity P Price Level GDP Deflator Y Quantity of Output Real GDP M Quantity of Money A theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate The theoretical separation of nominal and real variables The proposition that changes in the money supply do not affect real Quantity Equation services M x V P x Y Inflation Tax Fisher Effect The equation M x V P x Y which relates the quantity of money the velocity of money and the dollar value of the economy s output of goods and The revenue the government raises by creating money The one for one adjustment of the nominal interest rate to the inflation rate The resources wasted when inflation encourages people to reduce their Shoeleather Costs money holdings Menu Costs The cost of changing prices When the overall price level rises the value of money falls In the long run the overall level of prices adjusts to the level at which the demand for money equals the supply These five steps are the essence of the quantity theory of money The velocity of money is relatively stable over time Because velocity is stable when the central bank changes the quantity of money M it causes proportionate changes in the nominal value of output P Y The economy s output of goods and services Y is primarily determined by factor supplies labor physical capital human capital and natural resources and the available production technology In particular because money is neutral money does not affect output With output Y determined by factor supplies and technology when the central bank alters the money supply M and induces proportional changes in the nominal value of output P Y these changes are reflected in changes in the price level P result is a high rate of inflation Therefore when the central bank increases the money supply rapidly the Hyperinflation is generally defined as inflation that exceeds 50 per month The inflation tax is like a tax on everyone who holds money Nominal Interest Rate is the interest rate you hear about at your bank Real Interest Rate corrects the nominal interest rate for the effect of inflation to tell you how fast the purchasing power of your savings account will rise over time Real Interest Rate Nominal Interest Rate Inflation Rate Nominal Interest Rate Real Interest Rate Inflation Rate When the Fed increases the rate of monthly growth the long run result is both a higher inflation rate and a higher nominal interest rate Inflation does not in itself reduce people s real purchasing power Friedman Rule Moderate Deflation
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