INFLATION, INTEREST RATES, AND HYPERINFLATIONDemand for goods depends on the real interest rate:Y = A(Y, i-B)Demand for money on the nominal interest rate:M/P = L(Y, i)In the long run, economy tends to natural rate of output Yn. Thismeans that it tends to “natural” real interest rate i-B = rnRecipe for steady inflation: let M grow at a steady rate )M/M = gMThen guess that price level also grows at a steady rate B = gM,and that real interest rate remains at rn. Then )(M/P)/(M/P) = )M/M - )P/P = 0So M/P constant; Y constant at Yn, i constant at rn + gMEnd of storyBut notice that higher B => higher i => lower M/PSEIGNORAGE: THE REVENUE FROM MONEY PRINTINGGovernment gets “revenue” by printing additional money; thereal revenue isS = )M/P (change in money supply divided by price level)or rewrite itS = ()M/M)(M/P) = gM(M/P)In steady inflation, however, i = rn+gM - and M/P is a decreasingfn. of iSo seignorage does not necessarily increase with rate of moneygrowth; typical shape is “inverted U”:)MM'SM/PBut what if the government “needs” seignorage greater thanmaximum?Turn the equation around:As people start to expect inflation, M/P falls; this means )M/Mrises; means further fall in M/P, etc.Result:Hyperinflation!!FIXED EXCHANGE RATES AND DEVALUATIONAggregate demand in an open economy with a fixed exchangerate:No monetary policy! i = i*So Y = A(Y, i*) + NX(Y, Y*, EP*/P)Higher P means lower output because it makes our goods lesscompetitive on world marketMeanwhile, AS curve: P = P-1G(Y, z)Suppose we increase E (a devaluation):A devaluation can produce only a temporary expansion inoutput. But suppose for some reason the economy is currentlybelow Yn. Then a devaluation can “truncate” the process ofadjustment, eliminating need for a prolonged deflation:OPTIMAL CURRENCY AREA: Tradeoff betweenmacroeconomic advantages of devaluation or floating,microeconomic advantages of fixed rates or common currency(reduced costs of doing business, less uncertainty)Should two countries fix rates, perhaps adopt commoncurrency?Factors to consider:1. Labor mobility (makes adjustment easy)2. Large volume of trade (makes uncertainty costly)3. Fiscal arrangements (can cushion adjustment)4. Similarity of economic structure5. Credibility issuesSome interesting cases: Europe; Argentina; Australia;
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