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PRINCIPLES OF MACROECONOMICS Lecture-08 Inflation Prepared by Oyshi Das Tonny  Money Growth and Inflation The increase in the overall level of prices is called inflation. When the price level falls, it’s called deflation. In February 20...

PRINCIPLES OF MACROECONOMICS Lecture-08 Inflation Prepared by Oyshi Das Tonny  Money Growth and Inflation The increase in the overall level of prices is called inflation. When the price level falls, it’s called deflation. In February 2008, the central bank of Zimbabwe announced the inflation rate in its economy had reached 24,000 percent; some independent estimates put the figure even higher. An extraordinarily high rate of inflation such as this is called hyperinflation. What determines whether an economy experiences inflation and, if so, how much? This chapter answers this question by developing the quantity theory of money.  The Classical Theory of Inflation We begin our study of inflation by developing the quantity theory of money. This theory is often called “classical” because it was developed by some of the earliest economic thinkers. Most economists today rely on this theory to explain the long run determinants of the price level and the inflation rate. The economy’s overall price level can be viewed in two ways. 1. The Level of Prices 2. The Value of Money  Money Supply, Money Demand, and Monetary Equilibrium What determines the value of money? The supply and demand for money determines the value of money. Thus, our next step in developing the quantity theory of money is to consider the determinants of money supply and money demand. How the Supply and Demand for Money Determine the Equilibrium Price Level  The Effects of a Monetary Injection Let’s now consider the effects of a change in monetary policy. Suddenly, the Fed doubles the supply of money by printing some dollar bills. What happens after such a monetary injection? How does the new equilibrium compare to the old one? This explanation of how the price level is determined and why it might change over time is called the quantity theory of money. According to the quantity theory, the quantity of money available in an economy determines the value of money, and growth in the quantity of money is the primary cause of inflation. As economist Milton Friedman once put it, “Inflation is always and everywhere a monetary phenomenon.” An Increase in the Money Supply  The Classical Dichotomy and Monetary Neutrality How do monetary changes affect other economic variables, such as production, employment, real wages, and real interest rates? This question has long intrigued economists, including David Hume in the 18th century. Hume and his contemporaries suggested that economic variables should be divided into two groups. The first group consists of nominal variables—variables measured in monetary units. The second group consists of real variables— variables measured in physical units. The separation of real and nominal variables is now called the classical dichotomy. And the irrelevance of monetary changes for real variables is called monetary neutrality.  Velocity and the Quantity Equation The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. This equation states that the quantity of money (M) times the velocity of money (V) equals the price of output (P) times the amount of output (Y). It is called the quantity equation because it relates the quantity of money (M) to the nominal value of output (P×Y).  The Fisher Effect According to the principle of monetary neutrality, an increase in the rate of money growth raises the rate of inflation but does not affect any real variable. For the real interest rate not to be affected, the nominal interest rate must adjust one-for-one to changes in the inflation rate. Thus, when the Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate. This adjustment of the nominal interest rate to the inflation rate is called the Fisher effect, after economist Irving Fisher (1867–1947), who first studied it.  The Costs of Inflation A Fall in Purchasing Power? The Inflation Fallacy Shoeleather Costs Menu Costs