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121

Inflation

Inflation is an increase in the overall level of prices.

122

Deflation

Deflation is a decrease in the overall price level.

123

Hyperinflation

Hyperinflation is an extraordinarily high rate of inflation. Hyperinflation is inflation that exceeds 50 percent per month.

124

The Causes of Inflation

The level of prices and the value of money

Money supply, money demand and monetary equilibrium

125

Money supply

Determined by the central bank. The RBA no longer targets the money supply. Instead it targets interest rates and inflation. Assuming the central bank targets the supply of money, the supply of money will be vertical (perfectly inelastic.

126

Money demand

Mainly determined by the price level. The higher prices are, the more money that is needed to perform transactions. A higher price level leads to a higher quantity of money demanded.

127

Nominal and real variables

Nominal variables are variables measured in monetary units.
Real variables are variables measured in constant units.
This separation is the classical dichotomy.
According to the classical dichotomy, different forces influence real and nominal variables.

128

The classical dichotomy and monetary neutrality

Real economic variables do not change with changes in the money supply.
Changes in the money supply affect nominal variables but not real variables.
The irrelevance of monetary changes for real variables is called monetary neutrality.

129

Velocity of money

The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

130

Velocity (V)

= nominal GDP (P × Y) / money supply (M)

(P*Y)/M

131

The quantity equation

M * V = P * Y

132

Velocity and the quantity equation

The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of the three other variables:
the price level must rise
the quantity of output must rise, or
the velocity of money must fall.

133

Explaining the equilibrium price level, inflation rate and the quantity theory of money:

Assume the velocity of money is relatively stable over time.

When the central bank
changes the quantity of money, it causes proportionate changes in the nominal value of output (P * Y).

Because money is neutral, money does not affect output.

When the central bank alters the money supply, these changes are reflected in prices.

Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.

134

Is the velocity of money relatively stable over time

Yes

135

The equilibrium price level

If the price level is above the equilibrium level, people will want to hold more money than is available and prices will have to decline. If the price level is below equilibrium, people will want to hold less money than that available and the price level will rise.

136

The effects of a monetary injection explained

The immediate effect of an increase in the money supply is to create an excess supply of money. People try to get rid of this excess supply by buying hoods and services with the funds or using these excess funds to make loans to others. The leads to increases in the demand for goods and services. Because the supply of goods and services has not changed, the result of an increase in the demand for goods and services will be higher prices.

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137

Maintaining Price Stability

An increase in the money demand. The central bank increases money supply. No change in the value of money. Price level stays constant.

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138

inflation tax

An inflation tax is like a tax on everyone who holds money.

139

The Fisher effect

the Fisher effect: How does the nominal and real interest rate respond to the inflation rate?

Nominal interest rate = real interest rate + inflation rate

According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same.

140

Inflation-induced tax distortion

Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.
With progressive taxation, capital gains are taxed more heavily
The income tax system treats the nominal interest earned on savings as income
The after-tax real interest rate falls, making saving less attractive.

141

How inflation raises the tax burden on saving

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142

Why do central banks commonly have inflation targets of around 2% rather than 0% (which would be perfect price stability)?

There are two main reasons:

Keeping well away from deflation

Being able to reduce interest rates by more in a downturnv

143

Economists have identified 5 costs of inflation

Shoeleather costs

Menu costs

Confusion and inconvenience

Inflation-induced tax distortions

Relative-price variability and the misallocation of resources

144

P

Price Level (GDP Deflator)

145

Y

Real GDP

146

M

Quantity of money

147

When the central bank
changes the quantity of money, it causes proportionate changes in the nominal value of output (P * Y).

The economy's output of goods and services (Y) is determined primarily by available resources and technology. Price level (P) increases proportionately with the change in M

148

The level of prices and the value of money

When the price level rises people have to pay more for the goods and services that they purchase. A rise in the price level also means that the value of money is now lower because each dollar now buys a smaller amount of goods and services. If P is the price level as measured by the CPI or the GDP deflator then the quantity of goods and services that can be purchased with $1 is equal to 1/P. If P increases, value of money (purchasing power) decreases.

149

Money supply, money demand and monetary equilibrium

The value of money is determined by the supply and demand for money.

150

Quantity theory of money

The quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate.