Transcript Chapter 28

Inflation is defined as an
increase in the overall level of
prices.
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When the general price level rises, each
unit of currency buys fewer goods and
services
inflation is also a decline in the real value
of money—a loss of purchasing power in
the medium of exchange which is also the
monetary unit of account in the economy.
Inflation originally referred to the debasement
of the currency.
When gold was used as currency, gold coins
could be collected by the government (e.g.
the king or the ruler of the region), melted
down, mixed with other metals such as silver,
copper or lead, and reissued at the same
nominal value.
By diluting the gold with other metals, the government
could increase the total number of coins issued without
also needing to increase the amount of gold used to
make them. When the cost of each coin is lowered in
this way, the government profits from an increase in
seigniorage (/ˈseɪnjərɪdʒ/), that is the net revenue
derived from the issuing of currency).
This practice would increase the money supply but at the
same time lower the relative value of each coin.
 As the relative value of the coins decrease, consumers
would need more coins to exchange for the same goods
and services. These goods and services would
experience a price increase as the value of each coin is
reduced.
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economists categorized three separate
factors that cause a rise or fall in the
price of goods:
◦ a change in the value or resource costs of the
good,
◦ a change in the price of money which then was
usually a fluctuation in metallic content in the
currency, and
◦ currency depreciation resulting from an
increased supply of currency relative to the
quantity of redeemable metal backing the
currency.
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Following the proliferation of private bank
note currency printed during the American
Civil War, the term "inflation" started to
appear as a direct reference to the currency
depreciation that occurred as the quantity
of redeemable bank notes outstripped the
quantity of metal available for their
redemption.
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A consumer price index (CPI) is a measure of
the average price of consumer goods and
services purchased by households. It is a
price index determined by measuring the
price of a standard group of goods meant to
represent the typical market basket of a
typical urban consumer.
GDP deflator (implicit price deflator for GDP)
is a measure of the level of prices of all new,
domestically produced, final goods and
services in an economy.
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Producer price indices (PPIs) which measures average
changes in prices received by domestic producers for
their output.
This differs from the CPI in that price subsidization,
profits, and taxes may cause the amount received by
the producer to differ from what the consumer paid.
There is also typically a delay between an increase in
the PPI and any eventual increase in the CPI.
Producer price index measures the pressure being
put on producers by the costs of their raw materials.
This could be "passed on" to consumers, or it could
be absorbed by profits, or offset by increasing
productivity.
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Core price indices: because food and oil prices
can change quickly due to changes in supply and
demand conditions in the food and oil markets, it
can be difficult to detect the long run trend in
price levels when those prices are included.
Therefore most statistical agencies also report a
measure of 'core inflation', which removes the
most volatile components (such as food and oil)
from a broad price index like the CPI.
Because core inflation is less affected by short
run supply and demand conditions in specific
markets, central banks rely on it to better
measure the inflationary impact of current
monetary policy.
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The quantity theory of money is used to
explain the long-run determinants of the
price level and the inflation rate.
When the overall price level rises, the value
of money falls.
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How the price level is determined and why
it might change over time is called the
quantity theory of money.
 The
quantity of money available in the economy
determines the value of money.
 The primary cause of inflation is the growth in
the quantity of money.
The velocity of money refers
to the speed at which the
typical dollar bill travels
around the economy from
wallet to wallet.
V = (P x Y)/M
Where:
V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
 Rewriting
the equation gives the
equation of exchange:
MxV=PxY
The equation of exchange relates
the quantity of money (M) to the
nominal value of output (P x Y).
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The quantity equation shows that an
increase in the quantity of money in an
economy must be reflected in one or more
of three other variables:
 the
price level must rise,
 the quantity of output must rise, or
 the velocity of money must fall.
Nominal GDP, the Quantity of Money, and the
Velocity of Money
Indexes
(1960 = 100)
1,500
Nominal GDP
M2
1,000
500
Velocity
0
1960
1965
1970
1975 1980
1985
1990
1995
2000
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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 x Y).
Because money is neutral, money does not
affect output.
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Hyperinflation is inflation that exceeds
50 percent per month.
Hyperinflation occurs in some countries
because the government prints too much
money to pay for its spending.
(a) Austria
(b) Hungary
Index (Jan.
1921 = 100)
Index (Jan.
1921 = 100)
100,000
Price level
100,000
Price level
10,000
Money
supply
1,000
100
10,000
Money
supply
1,000
1921
1922 1923 1924 1925
100
1921
1922 1923 1924 1925
c) Germany
d) Poland
Index (Jan.
1921 = 100)
100 trillion
1 trillion
10 billion
Index (Jan.
1921 = 100)
Price level
10 million
Price level
Money
supply
1 million
100 million
100,000
1 million
10,000
Money
supply
10,000
1,000
100
1
100
1921 1922 1923 1924 1925
1921 1922 1923 1924 1925
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When the government raises revenue by
printing money, it is said to levy an
inflation tax.
An inflation tax is like a tax on everyone
who holds money.
The inflation ends when the government
institutes fiscal reforms such as cuts in
government spending.
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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.
Nominal interest rate =
Real interest rate + Inflation rate
Percent
(per year)
The Nominal Interest Rate
and the Inflation Rate
15
12
10
Nominal interest rate
6
3
Inflation
0
1960
1965 1970 1975 1980 1985 1990
1995
Shoeleather costs
 Menu costs
 Relative price variability
 Tax distortions
 Confusion and inconvenience
 Arbitrary redistribution of wealth
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Shoeleather costs are the resources wasted
when inflation encourages people to reduce
their money holdings.
Inflation reduces the real value of money,
so people have an incentive to minimize
their cash holdings.
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Less cash requires more frequent trips to
the bank to withdraw money from interestbearing accounts.
The actual cost of reducing your money
holdings is the time and convenience you
must sacrifice to keep less money on hand.
Also, extra trips to the bank take time
away from productive activities.
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Menu costs are the costs of adjusting
prices.
During inflationary times, it is necessary to
update price lists and other posted prices.
This is a resource-consuming process that
takes away from other productive
activities.
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Inflation distorts relative prices.
Consumer decisions are distorted, and
markets are less able to allocate
resources to their best use.
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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.
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The income tax treats the nominal interest
earned on savings as income, even though
part of the nominal interest rate merely
compensates for inflation.
The after-tax real interest rate falls,
making saving less attractive.
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When the central bank increases the
money supply and creates inflation, it
erodes the real value of the unit of
account.
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.
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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.
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The overall level of prices in an economy
adjusts to bring money supply and money
demand into balance.
When the central bank increases the supply of
money, it causes the price level to rise.
Persistent growth in the quantity of money
supplied leads to continuing inflation.
A government can pay for its spending simply
by printing more money.
This can result in an “inflation tax” and
hyperinflation.
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www.wikipedia.org
Czarny B. „Podstawy Ekonomii”, PWE, 2002
www.nbp.pl
http://windward.hawaii.edu/facstaff/briggsp/Macroeconomics/macrolectures.htm
www.money.pl/i/denominacja/inflacja_sm.gif