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Shoeleather costs

Because inflation erodes the value of money that you can carry in your pocket, you can avoid this drop in value by holding less money. Holding less money generally means more trips to the bank. The resources wasted when inflation encourages people to reduce their money holdings.


Menu costs

During periods of inflation, firms must change their prices more often. The costs of changing prices.


Confusion and inconvenience

When inflation occurs the value of money falls. This alters the yardstick that we use to measure important variables like incomes and profit.


Inflation-induced tax distortions

Law-makers rarely take into account inflation when they write tax laws.


Relative-price variability and the misallocation of resources

Because prices of most goods change only once in a while (instead of constantly), inflation causes relative prices to vary more than they would otherwise. Consumer decisions are distorted and markets are less able to allocate resources efficiently.


1. Two countries, Alpha and Beta, are otherwise identical except that each dollar in Alpha is used more frequently than each dollar in Beta. For this to be true, it must be the case that, holding other factors equal, __________ in Alpha than in Beta.

If both countries are identical then this means that trade and inflation is identical across both. According to the below “quantity theory of money” formula, this implies that only the velocity of money (number of times each dollar circulates) and stock of money varies between the nations. Hence, the nation with the higher velocity will have a smaller stock of money and vice versa.

Money stock x velocity = price level x quantity (production)


2. According to the quantity equation, if velocity and real GDP are constant and the Reserve Bank increases the money supply by five per cent, then the price level

a. decreases by 10 per cent

b. decreases by five per cent

c. is also constant

d. increases by five percent


Money stock X Velocity = Price Level X RDGP

With RGDP and velocity held constant, a percentage change in money stock must be fully reflected in an equal percentage change in the price level.


3. The demand for money is:

positively related to the price level



Photo 19/9


5. At point B in Graph 1:

a. the value of money is less than its equilibrium level

b. money supply is greater than money demand

c. the price level is higher than its equilibrium level

d. money demand is greater than money supply

At point B Money supply and money demand are not equal. The value of money is ½ at this point, the corresponding quantity of money demanded is equal to M1 (point A) whereas the quantity of money supplied is equal to M2 (point B). M2 is greater than M1, thus money supply is greater than money demand at this point


6. When the money supply curve in Graph 1 shifts from MS2 to MS1:

a. the equilibrium value of money increases

b. the equilibrium price level increases

c. the supply of money has increased

d. the demand for goods and services will increase



7. When the money supply curve in Graph 1 shifts from MS2 to MS1:

a. the equilibrium price level increases

b. this may be due to the RBA selling government securities

c. this is due to the RBA buying government securities

d. the demand for goods and services increasing


The value of money and the price level move in opposite directions. Each dollar is more valuable when it can be used to purchase a larger amount of goods and services. Thus, the value of money is higher when prices are lower. A decrease in the money supply (M2 to M1) achieved by the RBA selling government bonds will lead to an increase in the value of money (1/4 to ½) as inflationary pressures are reduced (as prices begin to fall).


8. What is the classical dichotomy

The classical dichotomy refers to the division of all economic variables into two groups, nominal variables and real variables


9. Define the quantity equation and illustrate how it affects the price level in the economy.

The quantity equation describes the relationship between money and nominal GDP. Recall that nominal GDP is the price level times real GDP. The quantity equation can then be written as money supply times velocity equal to price level times real GDP, or in symbols, M xV = P x Y.


Business cycle

Fluctuations in the economy are often called the business cycle



The aggregate-demand curve (AD) shows the quantity of goods and services that households, firms, and the government want to buy at each price level


Components of AD

The aggregate demand for goods and services has four components:

Aggregate Demand = C + I + G + NX

Aggregate Supply = Y

In equilibrium, supply = demand

Therefore, in equilibrium Y = C + I + G + NX


The aggregate-demand curve illustrated

Photo 15/9


Shifts in the Aggregate Demand Curve

PHOTO 15/9


Why the Aggregate-Demand Curve Might Shift

Shifts arising from

Consumption: consumer optimism, tax rates, prices of assets (stocks, bonds, real estate)

Investment: technological progress, business confidence, tax rates, money supply

Government Purchases

Net Exports: foreign GDP, expectations about exchange rates


The aggregate-supply curve

The aggregate-supply curve (AS) shows the quantity of goods and services that firms choose to produce and sell at each price level.


The long-run aggregate-supply curve

Photo 15/9


Why the Long-Run Aggregate-Supply Curve Might Shift

Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.


Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.

Labor: population growth, immigration, natural rate of unemployment

Capital, physical or human

Natural Resources: price of imported oil


Laws, government policies


The short-run aggregate-supply curve

We empirically observe that in the SR, unlike the LR, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied.
A decrease does the opposite
Put differently, P has temporary but not permanent positive effect on Y


The short-run aggregate-supply curve

Photo 15/8


Why is the SRAS upward sloping

(1) the misperceptions theory
(2) the sticky-wage theory
(3) the sticky-price theory


How the SRAS curve shifts

SRAS1 shows the aggregate supply curve for 2010
the expected price level and the natural rate of output, must be on the SRAS curve
If either Pe↓ or YN↑, the green dot moves down or to the right
When the green dot shifts, so must the AS curve

Photo 15/9


The long-run equilibrium

Photo 15/9


Two causes of recession

Case 1
Case 2