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Questions and Answers
What primarily determines real incomes in the long run?
What primarily determines real incomes in the long run?
What does inflation cause to rise together over the long run?
What does inflation cause to rise together over the long run?
Which cost is associated with the resources wasted due to reduced money holdings during inflation?
Which cost is associated with the resources wasted due to reduced money holdings during inflation?
What kind of costs arise when businesses change prices due to inflation?
What kind of costs arise when businesses change prices due to inflation?
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What issue arises from relative-price variability due to inflation?
What issue arises from relative-price variability due to inflation?
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How does inflation complicate long-range planning for businesses?
How does inflation complicate long-range planning for businesses?
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Which factor is NOT considered a cost of inflation?
Which factor is NOT considered a cost of inflation?
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What is the primary consequence of a government printing money to cover spending?
What is the primary consequence of a government printing money to cover spending?
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What does the term 'shoeleather costs' refer to during periods of high inflation?
What does the term 'shoeleather costs' refer to during periods of high inflation?
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What fraction of total revenue does the inflation tax account for in the U.S. today?
What fraction of total revenue does the inflation tax account for in the U.S. today?
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What typically initiates the process of hyperinflation?
What typically initiates the process of hyperinflation?
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What effect does inflation have on money holders?
What effect does inflation have on money holders?
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During which month in 2008 was the highest monetary value recorded?
During which month in 2008 was the highest monetary value recorded?
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What is the inflation tax primarily a result of?
What is the inflation tax primarily a result of?
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Why might a government resort to printing money?
Why might a government resort to printing money?
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What impact does inflation have on assets held in cash?
What impact does inflation have on assets held in cash?
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What does the velocity of money quantify?
What does the velocity of money quantify?
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If the money supply increases while nominal GDP remains constant, what happens to the velocity of money?
If the money supply increases while nominal GDP remains constant, what happens to the velocity of money?
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What is the nominal GDP if the real GDP is 3000 pizzas and the price of pizza is $10?
What is the nominal GDP if the real GDP is 3000 pizzas and the price of pizza is $10?
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In the example provided, what is the value of the velocity of money when the money supply is $10,000?
In the example provided, what is the value of the velocity of money when the money supply is $10,000?
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Which equation represents the relationship of nominal GDP in terms of price level and real GDP?
Which equation represents the relationship of nominal GDP in terms of price level and real GDP?
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If the price level rises but real GDP remains constant, what can be predicted about velocity?
If the price level rises but real GDP remains constant, what can be predicted about velocity?
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What does a velocity of 3 indicate in the context of transactions?
What does a velocity of 3 indicate in the context of transactions?
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What is the nominal GDP if the price per bushel is $5 and the quantity produced is 800 bushels?
What is the nominal GDP if the price per bushel is $5 and the quantity produced is 800 bushels?
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What does the formula for velocity (V) represent within the quantity equation?
What does the formula for velocity (V) represent within the quantity equation?
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Given MS = $2000 and nominal GDP = $4000, what is the velocity of money?
Given MS = $2000 and nominal GDP = $4000, what is the velocity of money?
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In the quantity equation M x V = P x Y, what does P represent?
In the quantity equation M x V = P x Y, what does P represent?
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Which of the following statements about velocity is correct?
Which of the following statements about velocity is correct?
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How is nominal GDP computed using the provided data?
How is nominal GDP computed using the provided data?
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If the money supply decreases while nominal GDP remains constant, what happens to velocity?
If the money supply decreases while nominal GDP remains constant, what happens to velocity?
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If velocity is constant and the money supply is $2000, what is the implication for nominal GDP if it is computed as $4000?
If velocity is constant and the money supply is $2000, what is the implication for nominal GDP if it is computed as $4000?
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What is the relationship between the money supply and inflation according to the quantity theory of money?
What is the relationship between the money supply and inflation according to the quantity theory of money?
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How do economists view the quantity theory of money?
How do economists view the quantity theory of money?
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Which of the following aspects does the money supply NOT directly affect?
Which of the following aspects does the money supply NOT directly affect?
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What analogy is used to describe inflation in the chapter?
What analogy is used to describe inflation in the chapter?
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What costs of inflation are mentioned in the chapter?
What costs of inflation are mentioned in the chapter?
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How might people perceive the effects of inflation?
How might people perceive the effects of inflation?
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In what way does too much money in circulation affect prices?
In what way does too much money in circulation affect prices?
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Which economic principle does the chapter primarily relate to money supply?
Which economic principle does the chapter primarily relate to money supply?
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What does P represent in the context of the value of money?
What does P represent in the context of the value of money?
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If the price level P is $4, what is the value of $1 in terms of goods in that scenario?
If the price level P is $4, what is the value of $1 in terms of goods in that scenario?
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What is the primary effect of inflation on the value of money?
What is the primary effect of inflation on the value of money?
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Which of the following correctly defines inflation?
Which of the following correctly defines inflation?
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Who is one of the key figures associated with the Quantity Theory of Money?
Who is one of the key figures associated with the Quantity Theory of Money?
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What does the Quantity Theory of Money assert?
What does the Quantity Theory of Money assert?
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Which two approaches are used to study the Quantity Theory of Money?
Which two approaches are used to study the Quantity Theory of Money?
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What is the relationship between general price rises and relative price changes?
What is the relationship between general price rises and relative price changes?
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Study Notes
Money Growth and Inflation
- Chapter 17 in the Principles of Macroeconomics, Sixth Edition, by N. Gregory Mankiw, focuses on money growth and inflation.
- The chapter addresses questions about how the money supply impacts inflation and nominal interest rates. It also explores if the money supply affects real variables like real GDP or real interest rates.
- The chapter examines how inflation acts like a tax and the various costs associated with inflation. The severity of these costs is also assessed.
- The quantity theory of money is introduced to explain one of the Ten Principles of Economics (from Chapter 1): Prices rise when the government prints too much money.
- Most economists view the quantity theory as a good explanation for long-run inflation behavior.
Introduction
- This chapter introduces the quantity theory of money to explain one of the Ten Principles of Economics from Chapter 1.
- Prices rise when the government prints too much money.
- Most economists believe that the quantity theory provides a good explanation of long-run inflation.
The Value of Money
- P is the price level (CPI or GDP deflator).
- P represents the price of a basket of goods measured in money.
- 1/P is the value of a dollar measured in goods.
- Inflation raises prices and lowers the value of money.
The Value of Money
- Inflation is the increase in the price level.
- Inflation is distinct from relative price changes.
- Inflation increases prices and decreases the value of money.
The Quantity Theory of Money
- Developed by 18th-century philosopher David Hume and classical economists, advocated by Milton Friedman.
- The quantity of money determines the value of money.
- This theory is studied using two approaches: a supply-demand diagram and an equation.
Money Supply (MS)
- In the real world, the money supply is influenced by the Federal Reserve, the banking system, and consumers.
- In the model, the Federal Reserve (Fed) precisely controls the money supply.
Money Demand (MD)
- Money demand refers to how much wealth people hold in liquid form, depending on the price level.
- An increase in the price level (P) reduces the value of money, requiring more money to buy goods and services.
- Other factors affecting money demand include real income and interest rates.
The Money Supply-Demand Diagram
- As the value of money increases, the price level falls. A vertical money supply line, regardless of price level, intersects the demand curve at an equilibrium point.
- The quantity of money demanded is negatively related to the price level, with a negative relationship between the price level and value of money.
The Money Supply-Demand Diagram
- The Fed sets a fixed money supply, regardless of the price level. This money supply interacts with money demand, leading to adjustment to equate the quantity of money demanded with the money supplied, setting an equilibrium price level.
The Effects of a Monetary Injection
- Increasing the money supply (MS) initially causes an excess supply of money in the market.
- People typically spend or lend excess money, leading to increased demand for goods.
- Without increased supply, prices must rise accordingly.
A Brief Look at the Adjustment Process
- Increasing the money supply (MS) causes the price level to rise.
- The increase in MS leads to an excess supply of money, forcing people to spend or lend this extra money.
- This increased demand for goods raises prices due to the fixed good supply, regardless of the money supply.
Real vs. Nominal Variables
- Nominal variables are measured in monetary units (e.g., nominal GDP, interest rate, wage).
- Real variables are measured in physical units (e.g., real GDP, interest rate, wage) and are adjusted for inflation.
- Relative prices are also measured in physical units and are considered real variables because they show the price of one good versus another.
Real vs. Nominal Wage
- The real wage is the wage adjusted for inflation.
- Real wage is the price of labor, measured in terms of the current price level (relative to the price of output).
The Classical Dichotomy
- Classical dichotomy is the theoretical separation of nominal and real variables.
- Hume's classical economists posited that monetary developments impact only nominal variables, not real variables.
- If the central bank doubles the money supply, nominal variables (like prices) double, while real variables remain unchanged.
The Neutrality of Money
- Monetary neutrality states that changes in the money supply do not affect real variables.
- Doubling the money supply will double nominal prices, but relative prices remain unchanged.
- Real wage, quantity of labor, and total employment are invariant to money supply changes.
- Total output also remains unchanged.
The Velocity of Money
- Velocity of money is the rate at which money changes hands.
- The velocity formula is V = (PxY)/M, where V is velocity, P is the price level, Y is the real GDP, and M is the money supply.
The Velocity of Money
- Using an example with pizza, the velocity of money (V) is calculated. It measures how many times the average dollar changes hands during a given period.
The Quantity Equation
- The quantity equation derived from the velocity formula is MV = PY.
- Multiplying both sides of the velocity formula by the money supply results in the quantity equation.
The Quantity Theory in 5 Steps
- The Quantity Theory of Money is summarized in 5 steps. The money supply is initially stable; however, changing the supply causes nominal GDP to similarly increase. This change does not affect real variables (or real GDP or price). Price changes in the same percentage as the money supply, causing rapid inflation.
Costs of Inflation
- Inflation fallacy: inflation erodes real income due to prices and wages rising. However, it is not true in the long run, as real incomes are determined by real variables, not inflation.
- Shoeleather costs arise from reduced money holdings to avoid inflation's erosion of the money's value.
- Menu costs result from adjusting prices frequently.
- Misallocation of resources is a result of firms not simultaneously raising prices, disrupting relative prices.
- There is confusion and inconvenience because inflation changes the yardstick used for transactions, making long-range planning and comparing amounts over time difficult.
The Inflation Tax
- The inflation tax occurs when the government prints money to fund spending when tax revenue is insufficient.
- This is similar to a tax on all holders of money as the money becomes worth less.
- This tax is a smaller portion of the overall tax revenue in the U.S, compared to during instances of hyperinflation.
The Fisher Effect
- The Fisher effect describes the relationship between the nominal interest rate and the inflation rate, which is one-for-one. Changes in inflation impact the nominal rate, leaving the real rate unchanged. Hence, they move together one-for-one in the longer run.
Summary of the Quantity Theory
- The quantity theory of money explains inflation in the long run; economists use this theory. Price level depends on the money growth rate.
- The classical dichotomy is the separation of variables into real and nominal. Money affects nominal variables, but not real variables; economists believe this is the way the economy functions in the long run.
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Description
Explore Chapter 17 of N. Gregory Mankiw's Principles of Macroeconomics which delves into the relationship between money growth, inflation, and interest rates. Understand the implications of the quantity theory of money and the costs associated with inflation, along with the concept that excessive money supply leads to price increases. This chapter serves as a critical analysis of how money supply influences the economy.
