3-Inflation

3-Inflation - ECO3311 Ch8:Inflation Introduction In this...

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ECO 3311 Ch 8: Inflation
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Introduction In this chapter, we learn: what inflation is, and how costly it can be. how the quantity theory of money and the classical dichotomy allow us to understand where inflation comes from. how the nominal interest rate, the real interest rate, and inflation are related through the Fisher equation. the important link between fiscal policy and high inflation.
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From 1919 to 1923, prices in Germany rose by over a factor of a trillion and were rising 300-fold each month. Inflation is the percentage change in an economy’s overall price level. Hyperinflation is an episode of extremely high inflation, usually greater than 500 percent per year.
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The inflation rate is computed as an annual percentage change in the price level. P t is the price level in the year t : The Consumer Price Index (CPI) is a price index for a bundle of consumer goods. Since 1960, in the United States, inflation was at about 2 percent until the Great Inflation of the 1970s; after this period, inflation settled at about 2.5 percent.
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Case Study: How Much Is That? We can use the CPI to do a “units” calculation to evaluate the value of a good in 1950 in today’s dollars. Multiply the price of the good in 1950 times the ratio of the CPI in today’s dollars to the CPI in 1950 dollars.
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This “units” calculation shows that the price of goods in 1950 relative to today was not as large of a difference as the raw numbers would lead you to believe. Other price indexes are the CPI excluding food and energy prices and the GDP deflator.
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The Quantity Theory of Money We can think of money as paper currency. Historically, money was backed by gold or silver, but today currency is “fiat money” – paper that the government simply declares is worth a certain price. Money takes on value because we expect others will value it.
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Measures of the Money Supply The monetary base includes currency and accounts, called reserves, which private banks hold with the economy’s central bank, which pay no interest. Reserves ensure that banks have sufficient cash on hand in case there is a run on the bank asking for currency withdrawals.
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M1 adds demand deposits to the money base. M2 adds savings accounts and money market account balances to M1.
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As we add additional elements to the broader measures of the money, the accounts become less liquid. An asset is less liquid if it is harder to turn into currency in a short period.
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The quantity theory of money allows us to make the connection between money and inflation. Let
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This note was uploaded on 02/27/2011 for the course ECO 3311 taught by Professor Staff during the Spring '08 term at Texas Tech.

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3-Inflation - ECO3311 Ch8:Inflation Introduction In this...

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