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Chapter 8 - 8.1 Introduction In this chapter we learn...

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1 Chapter 8 Inflation Charles I. Jones 8.1 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 help us understand inflation inflation. – the relationship of interest rates and inflation through the Fisher equation. – the important link between fiscal policy and high inflation. • Inflation – the percentage change in an economy’s overall price level • Hyperinflation – an episode of extremely high inflation, – greater than 500 percent per year. – Example: Post WWI Germany The inflation rate is computed a percentage change in the price level Price level in The Consumer Price Index (CPI) – price index for a bundle of consumer goods. Price level in year t Case Study: How Much Is That? We can use the CPI to evaluate the value of a good in 1950 in today’s dollars.
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2 Multiply the price of the good in 1950 times the ratio of the CPI in today’s dollars to the CPI in 1950 dollars. Not as large of a difference as the raw numbers may lead you to believe. Other price indexes – the CPI excluding food and energy prices – the GDP deflator. 8.2 The Quantity Theory of Money We often think of money as paper currency. Historically • Historically – money was backed by gold or silver • Today – currency is “fiat money” paper that the government simply declares 8.2 The Quantity Theory of Money – paper that the government simply declares is worth a certain price. – Money has value because we expect others will value it. Measures of the Money Supply The monetary base includes currency and accounts, called reserves private banks hold accounts with the – private banks hold accounts with the economy’s central bank, which pay no interest. – ensure that banks have sufficient cash on hand in case of money withdrawals Other measures of currency: – M1 • adds demand deposits to the money base. M2 – M2 • adds savings accounts and money market account balances to M1.
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3 Case Study: Digital Cash Electronic forms of currency debit cards PayPal travelers’ checks – debit cards, PayPal, travelers checks – makes up most money in advanced economies The Quantity Equation The quantity theory of money allows us to make the connection between money and inflation. Price Level Real GDP Money Supply Velocity Of Money Velocity of money – the average number of times per year that each piece of paper currency is used in a transaction.
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