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Inflation is an increase in the overall level of prices.



Deflation is a decrease in the overall price level.



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


The Causes of Inflation

The level of prices and the value of money

Money supply, money demand and monetary equilibrium


What is the ‘easiest’ way to create high inflation?

Milton Friedman ‘Inflation is always and everywhere a monetary phenomenon.’

What does he mean?

The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.


Money supply

The money supply is a policy variable that is controlled by the central bank.
Through instruments such as open-market operations, the central bank directly controls the quantity of money supplied by the banking system.
Note that the RBA no longer targets the money supply. The RBA now targets interest rates and inflation.


Money demand

Money demand has several determinants, including interest rates and the average level of prices in the economy.
People hold money because it is the medium of exchange.
The amount of money people choose to hold depends on the prices of goods and services.


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.


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.


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.


Velocity (V)

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



The quantity equation

M * V = P * Y


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.


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.


Is the velocity of money is relatively stable over time



Money neutrality

The irrelevance of monetary changes for real variables is called money neutrality.


The equilibrium price level

In the long run The overall level of prices adjusts to the level at which the demand for money equals the supply

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The effects of a monetary injection explained

An increase in the money supply decreases the value of money and increases the price level.

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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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inflation tax

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


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.


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.


How inflation raises the tax burden on saving

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Confusion and inconvenience

Inflation causes dollars at different times to have different real values.
Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time


Arbitrary redistributions of wealth

Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.
These redistributions occur because many loans in the economy are specified in terms of the unit of account – money


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 downturn


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



Price Level (GDP Deflator)



Real GDP



Quantity of money