Answers to Textbook Questions and Problems CHAPTER 5 Inflation: Its Causes, Effects, and Social Costs Questions for Review 1. The quantity equation is an identity that expresses the link between the number of transactions that people make and how much money they hold. We write it as Money Velocity = Price Transactions M V = P T. The right side of the quantity equation tells us about the value of transactions in monetary terms that occur during a given period of time, for example, a year. T represents the total number of transactions. P represents the price of a typical transaction. Hence, the product P T represents the amount of dollars exchanged in a year. The left side of the quantity equation tells us about the money used to make these transactions. M represents the quantity of money in the economy. V represents the transactions velocity of money—the rate at which money circulates in the economy. Because the number of transactions is difficult to measure, economists usually use a slightly different version of the quantity equation, in which the total output of the economy Y replaces the number of transactions T: Money Velocity = Price Output M V = P Y. P now represents the price of one unit of output, so that P Y is the dollar value of output—nominal GDP. V represents the income velocity of money—the number of times a dollar bill becomes a part of someone’s income. 2. If we assume that velocity in the quantity equation is constant, then we can view the quantity equation as a theory to study the effect of changes in the money supple (M). The quantity equation with fixed velocity states that: MV = PY. If velocity V is constant, then a change in the quantity of money (M) causes a proportionate change in nominal GDP (PY). If we assume further that output is fixed by the factors of production and the production technology such that Y is constant in the equation, then we can conclude that the quantity of money determines the price level. This is called the quantity theory of money. 3. The holders of money pay the inflation tax. As prices rise, the real value of the money that people hold falls—that is, a given amount of money buys fewer goods and services since prices are higher. This loss of real purchasing power is akin to a ‘tax’ on the money held. 4. The Fisher equation expresses the relationship between nominal and real interest rates. It says that the nominal interest rate i equals the real interest rate r plus the inflation rate π: i = r + π. This tells us that the nominal interest rate can change either because the real interest rate changes or the inflation rate changes. The real interest rate is assumed to be unaffected by inflation; as discussed in Chapter 3, it adjusts to equilibrate saving and investment. There is thus a one-to-one relationship between the inflation rate and the nominal interest rate: if inflation increases by 1 percent, then the nominal interest rate also increases by 1 percent. This one-to-one relationship is called the Fisher effect. If inflation increases from 6 to 8 percent, then the Fisher effect implies that the nominal interest rate increases by 2 percentage points, while the real interest rate remains constant. 5. The costs of expected inflation include the following: a. Shoeleather costs. Higher inflation means higher nominal interest rates, which means that people want to hold lower real money balances. If people hold lower money balances, they must make more frequent trips to the bank to withdraw money. There is an element of inconvenience involved, which is referred to as the ‘shoeleather tax’ because colloquially, more trips to the bank to withdraw money results in the wearing out of the shoes. b. Menu costs. Higher inflation induces firms to change their posted prices more often. This may be costly if they must reprint their menus and catalogs. c. Greater variability in relative prices. If firms change their prices infrequently, then inflation causes greater variability in relative prices. Since free-market economies rely on relative prices to allocate resources efficiently, inflation leads to microeconomic inefficiencies. d. Altered tax liabilities. Many provisions of the tax code do not take into account the effect of inflation. Hence, inflation can alter individuals’ and firms’ tax liabilities, often in ways that lawmakers did not intend. e. The inconvenience of a changing price level. It is inconvenient to live in a world with a changing price level. Money is the yardstick with which we measure economic transactions. Money is a less useful measure when its value is always changing. There is an additional cost to unexpected inflation: f. Arbitrary redistributions of wealth. Unexpected inflation arbitrarily redistributes wealth among individuals. For example, if inflation is higher than expected, debtors gain and creditors lose. Also, people with fixed pensions are hurt because their dollars buy fewer goods. 6. Hyperinflation is always a reflection of monetary policy. That is, the price level cannot grow rapidly unless the supply of money also grows rapidly, and hyperinflations do not end unless the government drastically reduces money growth. This explanation, however, begs a central question: why does the government start and then stop printing large quantities of lots of money? The answer almost always lies in fiscal policy: when the government has a large budget deficit (for example due to a recent war or some other major event) that it cannot fund by borrowing, it resorts to printing money to pay its bills. Only when the fiscal problem is alleviated,—by reducing government spending and / or collecting more taxes,—can the government hope to slow its rate of money growth. 7. Real variables are measured in physical units, and nominal variables are measured in terms of money. Real variables have been adjusted for inflation and are often measured in terms of constant dollars, while nominal variables are measured in terms of current dollars. For example, real GDP is measured in terms of constant base-year dollars, while nominal GDP is measured in current dollars. An increase in real GDP means we have produced a larger total quantity of goods and services, valued in base-year dollars. As another example, the real interest rate measures the increase in your purchasing power, the quantity of goods and services you can buy with your dollars, while the nominal interest rate measures the increase in the amount of current dollars you possess. The interest rate you are quoted by your bank, for example 8 percent, is a nominal rate. If the inflation rate is 3 percent, then the real interest rate is 5 percent, meaning your purchasing power has only increased by 5 percent and not 8 percent. The quantity of dollars you possess has increased by 8 percent but you can only afford to buy 5 percent more goods and services with these dollars. Problems and Applications 1. a. To find the growth rate of nominal GDP, we start with the quantity equation MV = PY, and note that PY is equal to nominal GDP, or the value of the goods and services produced measured in current dollars. If we express this formula in percentage change form we have: % Change in M + % Change in V = % Change in PY. If we assume the percentage change in velocity is zero, then the percentage change in nominal GDP is equal to the percentage change in the money supply, or 8 percent. b. To find the inflation rate, express the quantity equation in percentage change form: b. To find the inflation rate, express the quantity equation in percentage change form: % Change in M + % Change in V = % Change in P + % Change in Y. Rearranging this equation tells us that the inflation rate is given by: % Change in P = % Change in M + % Change in V – % Change in Y. Substituting the information given in the problem, we thus find: % Change in P = 8% + 0% – 3% = 5%. c. The real interest rate is 4 percent: the nominal interest rate of 9 percent minus the inflation rate of 5 percent. 2. The money demand function is given as d M = kY . Ł P ł a. To find the average inflation rate the money demand function can be expressed in terms of growth rates: % Growth Md – % Growth P = % Growth Y. The parameter k is a constant, so it can be ignored. The percentage change in nominal money demand Md is the same as the growth in the money supply because nominal money demand has to equal nominal money supply. If nominal money demand grows 12 percent and real income (Y) grows 4 percent then the growth of the price level or the inflation rate is 8 percent. b. From the answer to part (a), it follows that an increase in real income growth will result in a lower average inflation rate. For example, if real income grows at 6 percent and money supply growth remains at 12 percent, then inflation falls to 6 percent. In this case, a larger money supply is required to support a higher level of GDP, resulting in lower inflation. c. The parameter k defines how much money people want to hold for every dollar of income. The parameter k is inversely related to the velocity of money. All else remaining the same, if people are holding fewer dollars, then each dollar must be used more times to purchase the same quantity of goods and services. d. If velocity growth is positive, then all remaining else the same inflation will be higher. From the quantity equation we know that: % Growth M + % Growth V = % Growth P + % Growth Y. Suppose that the money supply grows by 12 percent and real income grows by 4 percent. When velocity growth is zero, inflation is 8 percent. Suppose now that velocity grows 2 percent; this will cause prices to grow by 10 percent. Inflation increases because the same quantity of money is being used more often to purchase the same amount of goods. In this case, the money supply should grow more slowly to compensate for the positive growth in velocity. 3. a. To find an expression for the velocity of money, start with the quantity equation MV=PY, and rewrite this as M/P=Y/V. In equilibrium real money supply M/P is equal to real money demand so: . 2 = 5 . Velocity depends positively on the nominal interest rate because when nominal interest rates are higher, there is an incentive to hold less money. If people are holding less money, then the dollars they are holding will be used more often and velocity will increase. b. If the nominal interest rate is 4 percent then velocity is equal to 10. c. We can rewrite the real money demand equation as: . 2 = . In equilibrium nominal money demand is equal to nominal money supply so Md is equal to $1,200. Given output Y is 1,000 and the nominal interest rate is 4 percent we find the price level is 12. d. According to the Fisher effect, a 5 percent increase in expected inflation will increase the nominal interest rate by 5%, so the new nominal interest rate is 9 percent. e. The new velocity of money is 15. f. The new price level is 18. The increase in the expected inflation rate will reduce the real demand for money. As a result the price level must rise to balance real money supply and real money demand, given nominal money supply did not change. This follows from the equation: Real Money Demand = . g. The money supply should be set at 800. 4. The money demand function is given as d M Y = L(i,Y) = . Ł P ł 5i a. If output Y grows at rate g, then real money balances (M/P)d must also grow at rate g, given that the nominal interest rate i is a constant. b. To find the velocity of money, start with the quantity equation MV = PY and rewrite the equation as V = (PY)/M = (P/M)Y. Now, note that P/M is the inverse of the real money supply, which is equal to real money demand. Therefore, the velocity of money is V = (5i/Y) Y, or V = 5i. c. If the nominal interest rate is constant, then the velocity of money must be constant. d. A one-time increase in the nominal interest rate will cause a one-time increase in the velocity of money. There will be no further changes in the velocity of money. e. To achieve a target inflation rate of the nominal money supply must grow at rate . For a given level of real output Y and a given velocity of money v, the percentage change in the money supply M will equal the percentage change in the price level P. 5. a. Legislators wish to ensure that the real value of Social Security and other benefits stays constant over time. This is achieved by indexing benefits to the cost of living as measured by the consumer price index. With indexing, nominal benefits change at the same rate as prices. b. Assuming the inflation rate is measured correctly (see Chapter 2 for more on this issue), senior citizens are unaffected by the lower rate of inflation. Although they get less money from the government, the goods they purchase are cheaper; their purchasing power is exactly the same as it was with the higher inflation rate. 6. A paper weapon might have been effective for all the reasons that hyperinflation is bad. For example, a large increase in the money supply increases shoeleather and menu costs; it makes relative prices more variable; it alters tax liabilities in arbitrary ways; it increases variability in relative prices; it makes the unit of account less useful; and finally, it increases uncertainty and causes arbitrary redistributions of wealth. If the hyperinflation is sufficiently extreme, it can undermine the public’s confidence in the economy and economic policy. Note that if foreign airplanes dropped the money, then the government would not receive seigniorage revenue from the resulting inflation, so this benefit usually associated with inflation is lost. 7. a. When the company decides to issue a new catalogue monthly instead of quarterly, this is an example of menu costs. Productive resources will be taken from other activities in order to update the catalogue more frequently, so the price of the goods keeps up with the costs incurred by the company and the real value of their profit is maintained. b. Unexpected inflation is reducing the real value of the annuity. When there is unexpected inflation, creditors lose and debtors win. In this case, grandpa is the creditor since he is owed the $10,000 per year from the insurance company. The insurance company is the debtor and it wins because it is paying grandpa each year with dollars that are less valuable, reducing the real value of the amount it has to pay. c. Spending money quickly before it loses value is an example of shoe leather costs. Maria is diverting time and energy from other activities so that she can convert her money into goods and services before its value has eroded from the hyperinflation. She has no incentive to save her income. d. Gita is being taxed on her nominal gain and not her real gain. Gita earned a 5 percent nominal return (the $50,000) and had to pay 20 percent of this amount in taxes. Her real return was actually –5 percent (the 5 percent nominal return minus the 10 percent inflation), so if the tax rate had been defined as a percentage of real earnings, then she would not owe any tax. e. If your father earned $4 and you earn $9, then you are paid 125 percent more in nominal terms (5/4 times 100). You are only luckier than your father if the current price level is less than 125 percent higher than the price level during your father’s time. To figure out whether you are better off than your father, you would need to compare the two real wages. 8. Deflation is defined as a fall in the general price level, which is the same as a rise in the value of money. Under a gold standard, a rise in the value of money is a rise in the value of gold because money and gold are in a fixed ratio. Therefore, after a period of deflation, an ounce of gold buys more goods and services. This creates an incentive to look for new gold deposits and, thus, more gold is likely to be found after a period of deflation. More Problems and Applications to Chapter 5 1. With constant money growth at rate μ, the question tells us that the Cagan model implies that pt = mt + γμ. This question draws out the implications of this equation. a. One way to interpret this result is to rearrange to find: mt – pt = –γμ. That is, real balances depend on the money growth rate. As the growth rate of money rises, real balances fall. This makes sense in terms of the model in this chapter, since faster money growth implies faster inflation, which makes it less desirable to hold money balances. b. With unchanged growth in the money supply, the increase in the level of the money supply mt increases the price level pt one-for-one. c. With unchanged current money supply mt, a change in the growth rate of money μ changes the price level in the same direction. d. When the central bank reduces the rate of money growth μ, the price level will immediately fall. To offset this decline in the price level, the central bank can increase the current level of the money supply mt, as we found in part (b). These answers assume that, at each point in time, private agents expect the growth rate of money to remain unchanged. So the change in policy takes them by surprise—but once it happens, it is completely credible. A practical problem is that the private sector might not find it credible that an increase in the current money supply signals a decrease in future money growth rates. . In that case, they might expect future money supply rates to be adjusted by the rise in current money supply rates, leading to incorrect future predictions. e. If money demand does not depend on the expected rate of inflation, then the price level changes only when the money supply itself changes. That is, changes in the growth rate of money μ do not affect the price level. In part (d), the central bank can keep the current price level pt constant simply by keeping the current money supply mt constant. IN THIS CHAPTER, YOU WILL LEARN: ▪ The classical theory of inflation ▪ causes ▪ effects ▪ social costs ▪ “Classical”—assumes prices are flexible & markets clear ▪ Applies to the long run 1 The quantity theory of money ▪ A simple theory linking the inflation rate to the growth rate of the money supply. ▪ Begins with the concept of velocity Velocity ▪ Basic concept: the rate at which money circulates ▪ Definition: the number of times the average dollar bill changes hands in a given time period ▪ Example: In 2015, ▪ $500 billion in transactions ▪ money supply = $100 billion ▪ The average dollar is used in five transactions in 2015 ▪ So, velocity = 5 Velocity (continued) ▪This suggests the following definition: T V = M where V = velocity T = value of all transactions M = money supply Velocity (continued) ▪Use nominal GDP as a proxy for total transactions. Then, V= P Y M where P = price of output (GDP deflator) Y = quantity of output (real GDP) P × Y = value of output (nominal GDP) The quantity equation ▪ The quantity equation M × V = P × Y follows from the preceding definition of velocity. ▪ It is an identity: it holds by definition of the variables. Money demand and the quantity equation ▪ M/P = real money balances, the purchasing power of the money supply. ▪ A simple money demand function: (M/P )d = k Y where k = how much money people wish to hold for each dollar of income. (k is exogenous) Money demand and the quantity equation ▪ Money demand: (M/P )d = k Y ▪ Quantity equation: M × V = P × Y ▪ The connection between them: k = 1/V ▪ When people hold lots of money relative to their incomes (k is large), money changes hands infrequently (V is small). Back to the quantity theory of money ▪ Starts with quantity equation ▪ Assumes V is constant & exogenous:V V= Then, quantity equation becomes: M V P Y = M V P Y = How the price level is determined: ▪ With V constant, the money supply determines nominal GDP (P × Y ). ▪ Real GDP is determined by the economy’s supplies of K and L and the production function (Chapter 3). ▪ The price level is P = (nominal GDP)/(real GDP). ▪ Recall from Chapter 2: The growth rate of a product equals the sum of the growth rates. ▪ The quantity equation in growth rates: M V P Y + = + M V P Y The quantity theory of money assumes V is constant, so V = 0. V π (Greek letter pi ) denotes the inflation rate: The result from the preceding slide: Solve this result for π: P = P M P Y = + M P Y p= DM - DY M Y M Y = − M Y ▪ Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. ▪ Money growth in excess of this amount leads to inflation. The quantity theory of money (continued) M Y = − M Y ΔY/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the quantity theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. Confronting the quantity theory with data The quantity theory of money implies: 1. Countries with higher money growth rates should have higher inflation rates. 2. The long-run trend in a country’s inflation rate should be similar to the long-run trend in the country’s money growth rate. Are the data consistent with these implications? Seigniorage ▪ To spend more without raising taxes or selling bonds, the govt can print money. ▪ The “revenue” raised from printing money is called seigniorage. (pronounced SEEN-your-idge). ▪ The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. Inflation and interest rates ▪ Nominal interest rate, i not adjusted for inflation ▪ Real interest rate, r adjusted for inflation: r = i − π The Fisher effect ▪ The Fisher equation: i = r + π ▪ Chapter 3: S = I determines r . ▪ Hence, an increase in π causes an equal increase in i. ▪ This one-for-one relationship is called the Fisher effect. NOW YOU TRY Applying the theory Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4. a. Solve for i. b. If the Fed increases the money growth rate by 2 percentage points per year, find Δi. c. Suppose the growth rate of Y falls to 1% per year. ▪ What will happen to π? ▪ What must the Fed do if it wishes to keep π constant? ANSWERS Applying the theory V is constant, M grows 5% per year, Y grows 2% per year, r = 4. a. First, find π = 5 − 2 = 3. Then, find i = r + π = 4 + 3 = 7. b. Δi = 2, same as the increase in the money growth rate. c. If the Fed does nothing, Δπ = 1. To prevent inflation from rising, the Fed must reduce the money growth rate by 1 percentage point per year. Two real interest rates Notation: ▪ π = actual inflation rate (not known until after it has occurred) ▪ Eπ = expected inflation rate Two real interest rates: ▪ i – Eπ = ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan ▪ i – π = ex post real interest rate: the real interest rate actually realized Money demand and the nominal interest rate ▪ In the quantity theory of money, the demand for real money balances depends only on real income Y. ▪ Another determinant of money demand: the nominal interest rate, i. ▪ the opportunity cost of holding money (instead of bonds or other interest-earning assets). ▪ So, money demand depends negatively on i. The money demand function (MP LiY)d = ( , ) (M/P )d = real money demand, depends ▪ negatively on i i is the opp. cost of holding money ▪ positively on Y higher Y increases spending on g&s, so increases need for money (“L” is used for the money demand function because money is the most liquid asset.) The money demand function (MP LiY)d = ( , ) =L(r+E,Y) When people are deciding whether to hold money or bonds, they don’t know what inflation will turn out to be. Hence, the nominal interest rate relevant for money demand is r + Eπ. Equilibrium M =Lr( +E,Y) P The supply of real money balance What determines what? M =Lr( +E,Y) P variable how determined (in the long run) M exogenous (the Fed) r adjusts to ensure S = I Y Y FKL= ( , ) M P adjusts to ensure =LiY( , ) P How P responds to ΔM M =Lr( +E,Y) P ▪ For given values of r, Y, and Eπ , a change in M causes P to change by the same percentage—just like in the quantity theory of money. What about expected inflation? ▪ Over the long run, people don’t consistently over- or under-forecast inflation, so Eπ = π on average. ▪ In the short run, Eπ may change when people get new information. ▪ E.g.: The Fed announces it will increase M next year. People will expect next year’s P to be higher, so Eπ rises. ▪ This affects P now, even though M hasn’t changed yet... How P responds to ΔE π M =Lr( +E,Y) P ▪For given values of r, Y, and M , E i (the Fisher effect) (MP)d P to make (MP) fall to re-establish eq'm A common misperception ▪ Common misperception: inflation reduces real wages ▪ This is true only in the short run, when nominal wages are fixed by contracts. ▪ (Chapter 3) In the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate. ▪ Consider the data . . .The classical view of inflation ▪The classical view: A change in the price level is merely a change in the units of measurement. Then, why is inflation a social problem? The social costs of inflation …fall into two categories: 1. costs when inflation is expected 2. costs when inflation is different than people had expected 1. Shoeleather Cost ▪ Definition: the costs and inconveniences of reducing money balances to avoid the inflation tax. ▪ If π increases, i increases (why?), so people reduce their real money balances. ▪ Remember: In long run, inflation does not affect real income or real spending. ▪ So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash. 2. Menu Costs ▪ Definition: The costs of changing prices. ▪ Examples: ▪ cost of printing new menus ▪ cost of printing & mailing new catalogs ▪ The higher is inflation, the more frequently firms must change their prices and incur these costs. 3. Relative Price Distortions ▪ Firms facing menu costs change prices infrequently. ▪ Example: A firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall. ▪ Different firms change their prices at different times, leading to relative price distortions . . . . . . causing microeconomic inefficiencies in the allocation of resources. 4. Unfair Tax Treatment Some taxes are not adjusted to account for inflation, such as the capital gains tax. Example: ▪ Jan 1: you buy $10,000 worth of Apple stock ▪ Dec 31: you sell the stock for $11,000, so your nominal capital gain is $1,000 (10%). ▪ Suppose π = 10% during the year. Your real capital gain is $0. ▪ Yet, you must pay taxes on your $1,000 nominal gain! 5. General Inconvenience ▪ Inflation makes it harder to compare nominal values from different time periods. ▪ This complicates long-range financial planning. Additional cost of unexpected inflation: Arbitrary Redistribution of Purchasing Power ▪ Many long-term contracts not indexed, but based on Eπ. ▪ If π turns out different from Eπ , then some gain at others’ expense. Example: borrowers & lenders ▪ If π > Eπ , then (i − π) < (i − Eπ ) and purchasing power is transferred from lenders to borrowers. ▪ If π < E π, then purchasing power is transferred from borrowers to lenders. Additional cost of high inflation: Increased Uncertainty ▪ When inflation is high, it’s more variable and unpredictable: π turns out different from Eπ more often, and the differences tend to be larger, though not systematically positive or negative. ▪ So, arbitrary redistributions of wealth more likely. ▪ This increases uncertainty, making risk-averse people worse off. One benefit of inflation ▪ Nominal wages are rarely reduced, even when the equilibrium real wage falls. This hinders labor market clearing. ▪ Inflation allows the real wages to reach equilibrium levels without nominal wage cuts. ▪ Therefore, moderate inflation improves the functioning of labor markets. Hyperinflation ▪ Common definition: π ≥ 50% per month ▪ All the costs of moderate inflation described above become HUGE under hyperinflation. ▪ Money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of exchange). ▪ People may conduct transactions with barter or a stable foreign currency. What causes hyperinflation? ▪ Hyperinflation is caused by excessive money supply growth. ▪ When the central bank prints money, the price level rises. ▪ If it prints money rapidly enough, the result is hyperinflation. Why governments create hyperinflation ▪ When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money. ▪ In theory, the solution to hyperinflation is simple: stop printing money. ▪ In the real world, this requires drastic and painful fiscal restraint. The classical dichotomy Real variables: Measured in physical units— quantities and relative prices, for example: Nominal variables▪quantity of output prod: Measured cedin money units, e.g., ▪▪nominal wagereal wage: output earned per hour of work: Dollars per hour of work. ▪▪nominal interest ratereal interest rate: output earned in the future : Dollars earned in future by lending one dollar today.by lending one unit of output today ▪the price level: The amount of dollars needed to buy a representative basket of goods. The classical dichotomy ▪ Recall: Real variables were explained in Chapter 3, nominal ones in Chapter 5. ▪ Classical dichotomy: the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables. ▪ Neutrality of money: Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run. ▪ Velocity: the ratio of nominal expenditure to money supply, the rate at which money changes hands ▪ Quantity theory of money ▪ assumes velocity is constant ▪ concludes that the money growth rate determines the inflation rate ▪ applies in the long run ▪ consistent with cross-country and time-series data ▪ Nominal interest rate ▪ equals real interest rate + inflation rate ▪ the opp. cost of holding money ▪ Fisher effect: Nominal interest rate moves one-for-one with expected inflation. ▪ Money demand ▪ depends only on income in the quantity theory ▪ also depends on the nominal interest rate ▪ if so, then changes in expected inflation affect the current price level Costs of inflation ▪ Expected inflation shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation ▪ Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors Hyperinflation ▪ caused by rapid money supply growth when money printed to finance govt budget deficits ▪ stopping it requires fiscal reforms to eliminate govt’s need for printing money Classical dichotomy ▪ In classical theory, money is neutral—does not affect real variables. ▪ So, we can study how real variables are determined w/o reference to nominal ones. ▪ Then, money market eq’m determines price level and all nominal variables. ▪ Most economists believe the economy works this way in the long run. Solution Manual for Macroeconomics Gregory N. Mankiw 9781464182891, 9781319106058
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