Chapter 17 Review

# Chapter 17 Review - Chapter 17 Review Introduction...

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Chapter 17 Review Introduction Inflation is an increase in the overall level of prices. Deflation is a decrease in the overall level of prices. Hyperinflation is extraordinarily high inflation. There is great variation in inflation over time and across countries. In this chapter, we address two questions: What causes inflation, and why is inflation a problem? The answer to the first question is that inflation is caused when the government prints too much money. The answer to the second question requires more thought and will be the focus of the second half of this chapter. The Classical Theory of Inflation This section develops and employs the quantity theory of money as an explanation of the price level and inflation. When prices rise, it is rarely because products are more valuable but rather because the money used to buy them is less valuable. Thus, inflation is more about the value of money than about the value of goods. An increase in the overall price level is equivalent to a proportionate fall in the value of money. If P is the price level (the value of goods and services measured in money), then 1 / P is the value of money measured in terms of goods and services. If prices double, the value of money has fallen to 1/2 its prior value. The value of money is determined by the supply and demand for money. If we ignore the banking system, the Fed controls the money supply. Money demand reflects how much wealth people want to hold in liquid form. While money demand has many determinants, in the long run, one is dominant—the price level. People hold money because it is a medium of exchange. If prices are higher, more money is needed for the same transaction, and the quantity of money demanded is higher. Money supply and money demand need to balance for there to be monetary equilibrium. Monetary equilibrium is shown in Exhibit 1 for money supply MS 1 at point A. Recall that the value of money measured in goods and services is 1 / P . When the value of money is high, the price level is low and the quantity of money demanded is low. Therefore, the money demand curve slopes negatively in the graph. Since the Fed fixes the quantity of money, the money supply curve is vertical. In the long run, the overall level of prices adjusts to equate the quantity of money demanded to the quantity of money supplied. Suppose the Fed doubles the quantity of money in the economy from MS 1 to MS 2 . There is now an excess supply of money at the original price level. Since

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people now are holding more money than they desire, they will rid themselves of the excess supply of money by buying things—goods and services or bonds. Even if people buy bonds (lend money), the bond issuer (borrower) will take the money and buy goods and services. Either way, an injection of money increases the demand for goods and services. Since the ability of the economy to produce goods and services has not changed, an increase in the demand for goods and services raises the price level. The price level will continue to rise (and the value
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