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Inflation and unemployment®

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Stock of assetsStock of assets

Used for transactionsUsed for transactions

A type of wealthA type of wealth

Money

As a medium of exchange, money is used to buy goods and services. The ease at which an asset can be converted into a medium of exchange and used to buy other things is sometimes called an asset’s liquidity. Money is the economy’s most liquid asset.

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Inflation is an increase in the average level of prices, and a price is the rate at which money is exchanged for a good or service.Here is a great illustration of the power of inflation:In 1970, the New York Times cost 15 cents, the median price of a single-family home was $23,400, and the average wage in manufacturing was $3.36 per hour. In 2008, the Times cost $1.50, the price of a home was $183,300, and the average wage was $19.85 per hour.

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General rise in the price levelInflation reduces the “purchasing power” of money

Consumer Price Index (CPI)Focus on good and services purchased by household

Producer Price Index (PPI)Focus on production inputs purchased by

businessGDP Price Index

Measures price changes in the economy as a whole

MEASURES OF INFLATION

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It serves as a store of value, unit of account, and a medium of exchange. The ease with which money is converted into other things such as goods and services--is sometimes called money’s liquidity.

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Fiat money is money by declaration.It has no intrinsic value.

Commodity money is money thathas intrinsic value.

When people use gold as money, the economy is said to be on a gold standard.

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The quantity theory of money states that the central bank, whichcontrols the money supply, has the ultimate control over the inflation rate. If the central bank keeps the money supply stable,the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.

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The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in

the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.

The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in

the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.

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Economists call the interest rate that the bank pays the Nominal interest rate and the increase in your purchasing power the

real interest rate.

This shows the relationship between the nominal interest rateand the rate of inflation, where r is real interest rate, i is the

nominal interest rate and is the rate of inflation, and rememberthat is simply the percentage change of the price level P.

Economists call the interest rate that the bank pays the Nominal interest rate and the increase in your purchasing power the

real interest rate.

This shows the relationship between the nominal interest rateand the rate of inflation, where r is real interest rate, i is the

nominal interest rate and is the rate of inflation, and rememberthat is simply the percentage change of the price level P.

rr = = ii - - π

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The Fisher Equation illuminates the distinction between the real and nominal rate of interest.

Fisher Equation: Fisher Equation: ii = = rr + +

Actual (Market)Actual (Market)nominal rate ofnominal rate of

interestinterestReal rateReal rateof interestof interest

InflationInflation

The one-to-one relationshipbetween the inflation rate and the nominal interest rate isthe Fisher effect.

It shows that the nominal interest can change for two reasons: becausethe real interest rate changes or because the inflation rate changes.

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The quantity theory (MV = PY) is based on a simple money demand function: it assumes that the demand for real money balances is proportional to income. But, we need another determinant of the quantity of money demanded—the nominal interest rate.

The nominal interest rate is the opportunity cost of holding money:it is what you give up by holding money instead of bonds. So, the newgeneral money demand function can be written as:

(M/P)d = L(i, Y)

This equation states that the demand for the liquidity of real moneybalances is a function of income (Y) and the nominal interest rate (i).The higher the level of income Y, the greater the demand for realmoney balances.

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As the quantity theory of money explains, money supply and money demand together determine the equilibrium price level. Changes in the price level are, by definition, the rate of inflation. Inflation, in turn, affects the nominal interest rate through the Fisher effect. But now, because the nominal interest rate is the cost of holding money, the nominal interest rate feeds back into the demand for money.

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The inconvenience of reducing moneyholding is metaphorically called theshoe-leather cost of inflation, becausewalking to the bank more often inducesone’s shoes to wear out more quickly.

When changes in inflation require printingand distributing new pricing information,then, these costs are called menu costs.

Another cost is related to tax laws. Oftentax laws do not take into considerationinflationary effects on income.

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Unanticipated inflation is unfavorable because it arbitrarily redistributes wealth among individuals.

For example, it hurts individuals on fixed pensions. Often thesecontracts were not created in real terms by being indexed to a particular measure of the price level.

There is a benefit of inflation—many economists say that someinflation may make labor markets work better. They say it“greases the wheels” of labor markets.

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Hyperinflation is defined as inflation that exceeds 50 percent per month, which is just over 1percent a day.

Costs such as shoe-leather and menu costs are much worse with hyperinflation—and tax systems are grossly distorted. Eventually, when costs become too great with hyperinflation, the money loses its role as store of value, unit of account and medium of exchange. Bartering or using commodity money becomes prevalent.

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CONSEQUENCES OF INFLATION

Be politically and socially destabalizing

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