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Unformatted text preview: EC 151 Ch: 17 Monetary Growth and Inflation The classical theory of inflation
The classical theory of inflation The cost of inflation Agenda Principle # 9 prices rise when the government prints too much money Develop the theory of inflation Why is inflation a problem? What are the costs of inflation imposed on the society? The Classical theory of inflation Explains the long run determinants of the P level and the inflation rate Classical model The level of prices and the value of money Inflation more about the value of money than the value of goods economy wide phenomenon concerns the value of economy's medium of exchange we can view the P level as a measure of the value of money 1/P = value of money measured in terms of goods and services MS MD In the LR, the overall level of prices adjusts to the level at which the demand for money equals the supply MS, MD, and the monetary equilibrium MS, MD, and the monetary equilibrium Effects of monetary injection Quantity theory of money Adjustment process (SR) Immediate effect QS exceeds QD at the prevailing P Buy goods and services or make loans Injection of M increases the D for goods and services Economy's ability to supply goods and services has not changed excess S of money Greater D causes P for goods and services to increase Increase in P causes increase in QD of money The overall P level for goods and services adjusts to bring MS and MD into balance Why? Nominal variables Classical Dichotomy and monetary neutrality Real variables values measured in monetary units values measured in physical units the theoretical separation of nominal and variable the proposition that changes in MS do not affect real variables Classical dichotomy Monetary neutrality Velocity and the Quantity equation Velocity of money rate at which money changes hands V = (P*Y)/M M*V = P*Y Quantity equation Quantity theory of money The velocity of money is relatively stable over time Because velocity is stable, when the central bank changes the Q of M, it causes proportional 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. Because money is neutral money does not affect output. With output (Y) determined by factor supplies and tech., when the central bank changes the supply of M and induces proportional changes in the nominal value of output (P*Y), these changes are reflected in changes in the P level Therefore when the central bank increases the money supply rapidly, the result is a high rate of inflation Case study: Money and P during four hyperinflations The inflation Tax, The Fisher effect Inflation tax The Fisher effect the revenue the government raises by creating money the inflation tax is like tax on everyone who holds money the onefor one adjustment of the nominal interest rate to the inflation when the FED increases the rate of money growth, the result is both higher inflation rate and higher nominal interest rate The inflation Tax, The Fisher effect The cost of inflation A fall in purchasing power? The inflation fallacy Shoeleather costs Menu Costs Relative P variability and the misallocation of resources Inflationinduced tax distortions The cost of inflation Inflationinduced tax distortions Confusion and inconvenience Arbitrary redistributions of wealth Case study: The wizard of OZ and the free silver debate ...
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