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Chapter 17 Money Growth and Inflation

Chapter 17 Money Growth and Inflation. Contents of the Chapter. Theoretical framework of inflation Money market & Money in long-run Velocity & quantity equation Why is inflation a problem?. The Classical Theory of Inflation.

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Chapter 17 Money Growth and Inflation

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  1. Chapter 17Money Growth and Inflation

  2. Contents of the Chapter • Theoretical framework of inflation • Money market & Money in long-run • Velocity & quantity equation • Why is inflation a problem?

  3. The Classical Theory of Inflation • Increase of nominal price level (price tags) is not caused by increase in demand but simply caused by decease in the value of money.

  4. What determines the value of money? • Supply and demand • Money Supply • Money Demand • How much cash people want to hold

  5. Application • An expansionary monetary policy (MS increases) • Decrease of the value of money • Increase of price level (inflation)

  6. The Classical Dichotomy and Monetary Neutrality • The classical dichotomy • Division of real and nominal variables in the economy • i.e. measured by money --- nominal measured by unit --- real (relative prices)

  7. The classical (cont’d) • Nominal variables: influenced by monetary system • Real variables: influenced by supply and demand

  8. Thus, changes of money supply will only affect nominal variables but not real variables: Monetary Neutrality. • Monetary Neutrality only exists in long-run not short-run.

  9. Velocity and Quantity Equation • Another perspective to look at money neutrality • Money supply is not only determined by physical amount of money but also velocity V = (P*Y)/M

  10. Quantity equation: M * V = P * Y • When you increase money supply: • Velocity the same -> increase price • Velocity the same -> quantity of output increases

  11. In practice, we find that money velocity is stable. Thus, if Fed increases money supply (in the long-run): • Quantity of output is the same ( sine it is only determined by real factors (not nominal factors, like money). • Only price will rise. • Faster money supply growth is, higher inflation we have

  12. Case study: What is the real cause of Hyperinflation • Government print too much money • Inflation tax

  13. Case study: Fisher Effect • Nominal and real interest rates in long-run • MS increases • Real interest rate stay put • Increases of MS are transferred to increases of nominal interest rate. • Why is it important? • Business contract. (inflation)

  14. Cost of Inflation • Inflation does not reduce people’s real purchasing power.

  15. Then, why inflation is bad for us? • Shoeleather costs • Menu costs • Relative Price Variability and the Misallocation of Resources • Tax • Unexpected Inflation: Arbitrary Redistributions of Wealth • Inconvenience

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