Why is the Inflation rate 2

# Why is the Inflation rate 2 - • Monetary neutrality...

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Why is the Inflation rate 2.5% in Canada but 19% in Venezuela? November 4, 2011 Classical theory of inflation Price of a good – reflects value Money – value falls as the price level rises Demand for money (households) – as prices rise we need more money to buy the same goods Increase price, we need more money as households 1/P M s (1/P 1 ) M d M 1 M d – shift out if Y rises or if households decide to increase their money holdings for some other reason M S vertical – position determined by the central bank Quantity theory of money Quantity theory of money: o The quantity of money determines the price level o The growth rate of money determines the inflation rate Classical dichotomy: the separation of real and nominal variables

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Unformatted text preview: • Monetary neutrality: changes in M S affect nominal variable, but not real variables Velocity • Velocity: the rate at which money changes hands • Example: o Produce 2000 cups of hot chocolate/week o \$2 per cup o \$500 of currency in the economy • How many times must each dollar change hands for all the hot chocolate to be purchased Quantity Equation M x V = P x Y M = Money, V = velocity, P = Price, Y = Real GDP (P x Y = nominal GDP) • The growth rate of the product of two variables is (approximately) equal to the sum of the growth rates of the individual variables • Δ M/M + Δ V/V = Δ P/P + Δ Y/Y Page 262, Question 1 M = \$50 B PY = \$1 000 B Y = \$500 B...
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