Chapter 14.docx - Chapter 14 Inflation and Deflation...

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Chapter 14: Inflation and Deflation Inflation is measured as the percentage change in prices over a period of time, typically one year. A hyperinflation is inflation of more than 50 percent per month (or roughly 13,000 percent per year). A deflation is a sustained period of negative inflation. In the long run, inflation is determined by the growth rate of the money supply. Sustained inflation means the central bank is expanding the money supply rapidly. Why would a central bank would pursue an inflationary policy? What level of inflation harms the economy? How does deflation occur and what are its effects? 14.1 Money and Inflation in the Long Run Monetary policy affects real output in the short run, but is neutral in the long run. Monetary policy has its strongest effects on the inflation rate in the long run. Expenditure and supply shocks cause year-to-year changes in the inflation rate. Average inflation over long periods is closely tied to the growth of the money supply. Velocity and the Quantity Equation -the reason why money supply affects inflation is it affects the level of spending in the economy The velocity of money is the ratio of total spending to the money supply; it measures how quickly money circulates through the economy: V = total spending/ M If spending is $500 and the money supply is $100, velocity is 5 = (500/100). Total spending is nominal GDP; the price level ( P ) times real output ( Y ): V = PY/M Velocity is how quickly money circulates, or how many times $1 is spent over a year. The quantity equation of money is the relationship among the money supply, velocity and nominal GDP: MV = PY Quantity equation of money: says that total spending in the economy (PY) equals the money supply (M) times the number of times each dollar is spent (V) Velocity and Money Demand The concept of velocity is related to the concept of money demand, the amount of money. In equilibrium money demand, M d , and money supply, M , are equal, so we can rewrite the definition of velocity as: V = PY / M d The relationship says that given the level of nominal GDP, there is an inverse relationship between money demand and velocity; increases in money demand reduce velocity. Deriving the Inflation Rate The inflation rate is the growth rate of the price level.
Since the quantity equation always holds, the percentage changes of each side are equal: % change in ( MV ) = % change in ( PY ) The percentage change in MV is equal to the percentage changes in M and V and similarly for PY : (% change in M ) + (% change in V ) = (% change in P ) + (% change in Y ) The % change in P is the inflation rate, π, so substituting and rearranging: π = (% change in M ) + (% change in V ) - (% change in Y ) Inflation is determined by the percentage changes or growth rates of the money supply, velocity and real output: 2 growth rates that are outside the control of the central bank Since money is neutral, output growth is determined only by technology and resources.

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