Key points Chapter 17 Money Growth and Inflation Inflation is the increase in the overall level of prices Long periods of time during the 19th century fell victim to deflation the decrease in the overall level of prices The quantity theory of money also known as the classical theory first discussed by David Hume states that prices rise when the government prints too much money Inflation tends to be more about the value of money rather than the value of the goods it buys The price level works the same way it can either be inferred as the level of price of a product basket or as a measure of the value of money When the overall price levels rise the value of the money falls The supply and demand of money determines the value of money Low value of money leads to an increase in the quantity demanded of money That is the quantity of money decreases with high value of money and decreased price levels The velocity of money is relatively stable over time Real interest rate Nominal interest rate inflation rate Costs of inflation include shoeleather costs menu costs and increased variability of relative Inflation does not in itself reduce people s real purchasing power prices unintended changes in tax liabilities confusion and inconvenience and arbitrary redistributions of wealth Because prices change only once in a while inflation causes relative prices to vary more than they otherwise would When inflation distorts relative prices consumer decisions are distorted and markets are less able to allocate resources to their best use The tax code incorrectly measures real incomes in the presence of inflation Inflation is especially volatile and uncertain when the average rate of inflation is high Quantity theory of money A theory asserting that the quantity of money available determines the price level ad that the growth rate in the quantity of money available determines the inflation rate Two groups of economic variables Nominal variables Variables measured in monetary units For this reason nominal GDP is influenced by current prices and the money supply Example prices are nominal Real variables Variables measured in physical units Real DP is not affected by the current prices and money supply Example relative prices are real Classical dichotomy The theoretical separation of nominal and real variables Monetary neutrality The proposition that changes in the money supply do not affect real variables Velocity of money The rate at which money changes hands This is calculated by V velocity of money P price Index x Y real GDP M quantity of money Quantity equation M x V P x Y states that if the quantity of money increases then the price level must rise the quantity of output must rise or the velocity of money must fall Hyperinflation The inflation that exceeds 50 per month Inflation tax The revenue the government raises by creating money Fisher effect Irving Fisher 1867 1947 The one for one adjustment of the nominal interest Shoeleather costs The resources wasted when inflation encourages people to reduce their rate to the expected inflation rate money holdings Menu costs The costs of changing prices Capital gains The profits made by selling an asset for more than its purchase price Glossary