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economic variables are divided into 2 groups
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nominal and real values
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nominal values
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measured in monetary unit
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real values
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measured in physical units ex: production/ employment/ real wages
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separation of real and nominal values is called
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classical dichotomy- dollar prices are nominal and relative prices (like a bushel of corn being equal to two wheat bunches) is real
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real wages
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wages adjusted for inflation are considered a real variable because it measures the rate people exchange goods for a unit of labor
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classical dichotomy
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theoretical separation of real and nominal variables/ nominal values are influenced by the economies monetary system while money is irrelevant to real values/ it is useful because different forces influence real and nominal variables
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real wages balance the
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supply and demand for labor/ unemployment results when real wage is above equilibrium wage
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only in the short run money can affect
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real values
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classical analysis claims in the long run money affects
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nominal values but not real values
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velocity of money
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the rate at which money changes hands
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velocity of money (V) =
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[(price level/ GDP def) P x (real GDP) Y ]/ M (quantity of money)
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the velocity of money equation can be rewritten as
M x V = P x Y which states
M x V = P x Y which states
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the quantity of money times the velocity of money equals price level (price of output) times the real gdp (amount of output)
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M x V = P x Y shows that
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an increase in the quantity of money in an economy must be reflected in on the other 3 variables
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increase in the overall level of prices
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inflation
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inflation rate
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percentage change in the consumer price index or GDP deflator
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prices rise when the gov
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prints too much money
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inflation is more about the value of money than the
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value of goods
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economies price level can be viewed in two ways
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1) as the price of a basket of goods and services/ when the price level rises people pay more for goods and services
2) price level is a measure of the value of money/ a rise in price level means a low value of money because each dollar buys a smaller quantity of goods
2) price level is a measure of the value of money/ a rise in price level means a low value of money because each dollar buys a smaller quantity of goods
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what determines the value of money
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the supply and demand for money
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quantity of money supplied
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is a policy variable the Fed controls
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quantity of money demanded
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is determined by the average level of prices in the economy/ people hold money because it is a medium of exchange for goods/ how much money people hold is dependent on the prices for those goods so when price level rises the quantity of money demanded increases
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in the long run the money supply and money demanded are brought
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into equilibrium by the overall level of prices
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Price level above equilibrium
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causes people to want to hold more money
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price level below equilibrium
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causes people to hold less money
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Money supplied (MS) is
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vertical because it is controlled by the FED
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increase in the money supply makes the dollars more
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plentiful so then the increase in price level makes each dollar less valuable
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quantity theory of money
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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
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immediate effect of money injection so excess supply of money so people either
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buy more or deposit more which would increase the amount banks can loan out and allow others to buy more so the demand of goods and services increases but the ability to supply goods and services causes the prices of those goods and services to increase so an increase in price level increases the quantity of money demanded because people use more money for each purchase
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5 steps to explain why equilibrium price level and inflation rate are the essence of the quantity theory of money
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1) velocity of money is stable overtime
2) bc velocity is stable when the bank changes the quantity of money is causes proportionate changes in the nominal value of output (P x Y)
3) Y is determined by factors supplies (labor/ resources/ capital) and technology because money does not affect output
4) when the alters M and induces proportional changes in (P x Y) these changes are reflected in changes in P
5) when bank increases MS rapidly it results in high interest rates
2) bc velocity is stable when the bank changes the quantity of money is causes proportionate changes in the nominal value of output (P x Y)
3) Y is determined by factors supplies (labor/ resources/ capital) and technology because money does not affect output
4) when the alters M and induces proportional changes in (P x Y) these changes are reflected in changes in P
5) when bank increases MS rapidly it results in high interest rates
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hyperinflation changes
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MS and price level largely
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the inflation tax
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the revenue the government raises by creating money/ printing money causes inflation, which is like a tax on everyone who holds money
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the inflation tax ends when
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the gov institutes fiscal reforms like spending cuts
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principle of monetary neutrality
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an increase in the rate of money growth raises the rate of inflation but does not affect any real variable
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interest rates are important because they link the economy of the
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present and the economy of the future through their effects on savings and investment
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nominal interest rate
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one you are told at the bank (payment on the loan)
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real interest rates
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are nominal interest rates adjusted for expected inflation
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according to quantity of theory of money growth in the money supply
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determines inflation rate and demand/ supply of loanable funds determines real interest rates
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long run result of the FED increase the rate of money growth
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is both a higher nominal interest rate and higher inflation rate
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fisher effect
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nominal interest rates adjust to expected inflation in the long run
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inflation in its self does not reduce purchasing power
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when prices rise buyers pay more but seller get more money and because most people earn income by selling their services/ labor the inflation in income goes hand in hand with inflation in prices
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nominal income tends to keep pace with inflation
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increase in income = increase in inflation
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2 costs of inflation
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1) shoe leather costs
2) menu costs
2) menu costs
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shoes leather costs
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inflation is like a tax on the holders on money which changes peoples behavior/ people can avoid paying inflation tax by holding less money and storing more in interest bearing bank accounts/ so the cost of reducing your money holdings is called shoe leather costs because it causes people to make more bank trips and sacrifice time/ convince in order to hold less money
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menu costs
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the real costs of changing listed prices and inflation can cause you to change your menu prices more often
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prices change only once in a while so inflation causes relative prices to vary more which is important since
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the economy relies on relative prices to allocate scarce resources so inflation causes us to be less able to allocate resources best
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almost all taxes
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distort incentives because people alter behavior and resources are then not allocated efficiently
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many taxes become problematic with taxes since lawmakers
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fail to take inflation in account when writing tax laws
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inflation tends to raise the tax burden on income earned from
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savings
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example for how inflation discourages savings
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is the tax treatments of capital gains (profits made from selling an asset for more than you bought it) since inflation exaggerates the size of capital gains which increases the tax burden on this type of income
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income tax treats nominal interest earned on savings as income
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because after taxes real interest rates provide the incentive to save so saving is less attractive when there is inflation
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higher inflation discourages people from
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saving and since saving provides resources for investment which is key to long run economic growth ultimately when inflation raises the tax burden on saving it slows economic growth
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solution to tax burden is
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to index the tax system so the tax laws are rewritten to take in account effects on inflation
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solution for tax burden on capital gains
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is that we could use a price index to tax only the real gain instead of exaggerated inflation gain
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solution for tax burden on interest income
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is that the gov could only tax real interest income instead of nominal to exclude portion compensating for inflation
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fed is responsible for having money remain a reliable unit of account so when they increase they money supply
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and inflation increases then money reliability to be a unit of account decreases
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inflation makes investors less able to sort good firms from bad firms which
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impedes financial markets in the role of allocating savings to investment
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special cost of inflation occurs when
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inflation is not expected and comes in surprise since normally inflation is steady and predictable
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unexpected inflation redistributes
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wealth among the population because many loans in the economy are specified in the unit of account (money)
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inflation favors lenders and hurts
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the lender because it diminishes the real value of debt/ the borrowers can repay loan in less valuable dollars than anticipated
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deflation favors the lender and hurts the
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borrower because it increase the real value of debt so borrowers must repay in dollars more valuable than expected
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low average inflation means
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inflation rate is stable
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Friedman Effect
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deflation would lower the nominal interest rate due to the fisher effect and that lower in nominal interest rate would reduce the cost of holding money then shoeleather costs would reduce which would require deflation to equal real interest rates
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unexpected deflation and inflation
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both redistributes wealth
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primary cause in inflation is the
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growth in the quantity of money
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