Classical Theory of Inflation
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Questions and Answers

What does the Classical theory of inflation also known as?

The Quantity Theory of Money

What are the two ways to view an economy's 'Price Level'?

  • The CPI basket of goods' prices (correct)
  • The interest rates
  • The employment levels
  • The value of money (correct)

    • Mathematically, what does 'P' represent?

    Price Level (by CPI or GDP Def.)

    Mathematically, what does '1/P' represent?

    <p>Value of money in terms of goods and services</p> Signup and view all the answers

    What does the 'demand for money' refer to?

    <p>Reflects how much people want to hold in liquid form</p> Signup and view all the answers

    What is the most important variable/determinant in the 'demand for money'?

    <p>The average level of prices in the economy</p> Signup and view all the answers

    Define a 'monetary injection'.

    <p>When the Fed 'injects' money into the economy by buying open market bonds</p> Signup and view all the answers

    What does the 'Quantity Theory of Money' state?

    <p>The quantity of money available determines the price level and the growth rate of money determines the rate of inflation.</p> Signup and view all the answers

    What 3 things happen after a 'monetary injection'?

    <ol> <li>There is an excess supply of money. 2. People get rid of excess supply by spending or loaning. 3. Economy then reaches a new equilibrium.</li> </ol> Signup and view all the answers

    What are the two groups of economic variables?

    <p>Nominal variables</p> Signup and view all the answers

    Define a 'classical dichotomy' in economic terms.

    <p>The theoretical separation of nominal and real variables</p> Signup and view all the answers

    If the Fed were to double the money supply, which variables would be unaffected according to 'monetary neutrality'?

    <p>Real variables = production, employment, real wages, and real interest rates</p> Signup and view all the answers

    Aside from taxes, selling of stocks and bonds, etc., how does the government also raise more revenue?

    <p>By printing more money and raising more revenue, called an inflation tax</p> Signup and view all the answers

    Explain the 'inflation tax'.

    <p>When the government prints more money, the price level rises, causing dollar value to go down.</p> Signup and view all the answers

    Mathematically, how is the 'nominal interest rate' calculated?

    <p>Real interest rate + inflation rate</p> Signup and view all the answers

    Explain the Fisher effect.

    <p>The one-for-one directly proportionate adjustment of nominal interest rate to the inflation rate mathematically.</p> Signup and view all the answers

    Is the Fisher effect immediate or over the long run?

    <p>False</p> Signup and view all the answers

    Why does inflation not in itself reduce people's purchasing power?

    <p>Most people earn income by selling goods and services; therefore, there is no inflation in their incomes.</p> Signup and view all the answers

    Define 'shoeleather costs'.

    <p>The resources/money wasted when inflation encourages people to reduce their money holdings.</p> Signup and view all the answers

    Why do most firms not frequently change prices of products?

    <p>Menu costs</p> Signup and view all the answers

    What are 'menu costs'?

    <p>Costs which come with changing prices</p> Signup and view all the answers

    According to relative price variability, how would a firm keep prices 'constant' over the course of the year?

    <p>If inflation was 12% per year, Firm A would drop prices 1% per year.</p> Signup and view all the answers

    What can be said about price adjustments when there is higher inflation?

    <p>There is higher variability in price adjustments.</p> Signup and view all the answers

    What role do lawmakers play in making inflation more burdensome on tax laws?

    <p>Often don't take inflation into account when writing tax laws.</p> Signup and view all the answers

    Why does inflation raise the tax burden on income earned from savings?

    <ol> <li>Government will tax your 'nominal' capital gains on savings rather than 'real' capital gains, adjusted for inflation. 2. Tax code treats nominal interest (not real) savings as income.</li> </ol> Signup and view all the answers

    What would be a solution to the broken tax system which doesn't adjust for inflation?

    <p>Index the tax system (tax laws must be rewritten).</p> Signup and view all the answers

    What causes accountants to incorrectly report a firm's profits?

    <p>Inflation</p> Signup and view all the answers

    What confusion does inflation cause for investors?

    <p>Difficult getting accurate assessments of which firms are successful/unsuccessful.</p> Signup and view all the answers

    What are the effects of loss of confidence in financial markets?

    <p>More money saved which leads to less investment.</p> Signup and view all the answers

    What is an example of arbitrary distribution of wealth due to hyperinflation?

    <p>Joe owes Lender A $400 of interest from a loan. If hyperinflation occurs, money is worth less and Joe benefits at the expense of the creditor.</p> Signup and view all the answers

    Who does unexpected inflation distribute wealth among?

    <p>Creditors and debtors.</p> Signup and view all the answers

    Study Notes

    Classical Theory of Inflation

    • Also known as the Quantity Theory of Money.
    • Price Level (P) can be viewed through the CPI basket of goods or the value of money.

    Money and Prices

    • "P" represents the Price Level, measured by CPI or GDP Deflator.
    • "1/P" signifies the value of money in terms of goods and services.

    Demand for Money

    • Demand for money reflects the desire to hold liquid assets.
    • The average level of prices in the economy is the most crucial determinant of money demand.

    Monetary Policy

    • A monetary injection occurs when the Fed buys open market bonds to increase money supply.
    • According to the Quantity Theory of Money, the amount of money affects the price level and inflation rate.

    Effects of Monetary Injection

    • Results in an excess supply of money.
    • Individuals spend or loan out the excess, leading to a new economic equilibrium.

    Economic Variables

    • Variables are categorized into nominal (measured in money) and real (measured in physical units).
    • Classical dichotomy separates nominal and real variables conceptually.

    Neutrality of Money

    • Doubling the money supply does not affect real variables like production, employment, or real interest rates.

    Government Revenue and Inflation Tax

    • Governments can raise funds by printing more money, known as inflation tax.
    • Inflation leads to rising price levels, diminishing the value of money.

    Interest Rates

    • The nominal interest rate is calculated as the real interest rate plus the inflation rate.
    • The Fisher effect indicates a one-to-one adjustment of nominal interest rates to inflation rates over the long run.

    Purchasing Power and Income

    • Inflation does not inherently reduce purchasing power since income typically rises with inflation.

    Costs of Inflation

    • Shoeleather costs result from people minimizing liquid cash holdings, leading to increased trips to the bank.
    • Menu costs are expenses associated with changing prices, discouraging frequent price adjustments.

    Impacts of Inflation on Firms

    • Firms tend to maintain stable prices despite inflation, which results in higher price variability over time.

    Tax Implications of Inflation

    • Lawmakers often overlook inflation in tax legislation, increasing the tax burden on nominal gains instead of real gains.
    • A proposed solution is to index the tax system for inflation adjustments.

    Effects on Corporate Profits and Investment

    • Inflation complicates profit calculations for accountants and can mislead investors about firms' performances.
    • Loss of confidence in financial markets leads to increased savings and reduced investment.

    Arbitrary Wealth Distribution

    • Hyperinflation can result in arbitrary wealth distribution between debtors and creditors; the impact reverses with deflation.

    Summary

    • Unexpected inflation redistributes wealth among creditors and debtors, creating disparities in financial responsibility.

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    Description

    This quiz explores the Classical Theory of Inflation, also known as the Quantity Theory of Money. It covers concepts such as the relationship between money supply and price levels, demand for money, and the effects of monetary policy. Test your understanding of how monetary injections influence economic variables and equilibrium.

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