17.1 The Classical Theory of Inflation
17.1 a. The Price Level and the Value of Money
The value of money refers to what a unit of money can buy, whereas the price level refers to the average of all of the prices of goods and services in a given economy. The basic causal relationship between the price level and the value of money is that as the price level goes up, the value of money goes down [1].
Example: In the U.S., the price level rises between 2 and 3 percent per year on average, doubling every 26 years. Thus, the amount of goods that $1 can buy slowly decreases every year and is halved every 26 years [1].
Price Levels [2]
17.1 b. Money Supply, Money Demand, and Monetary Equilibrium
The relationship between interest rates and the quantity of money demanded is an application of the law of demand. Its downward slope expresses the negative relationship between the quantity of money demanded and the interest rate. We assume that the quantity of money supplied in the economy is determined as a fixed multiple of the quantity of bank reserves, which is determined by the Fed. The supply curve of money is a vertical line at that quantity. The market for money is in equilibrium if the quantity of money demanded is equal to the quantity of money supplied [3].
Example: The Fed increases the money supply by buying bonds, increasing the demand for bonds. This corresponds to an increase in the money supply. The interest rate must fall to achieve equilibrium. The lower interest rate leads to an increase in investment and net exports, which shifts the aggregate demand curve. Real GDP and the price level rise [3].
Money Market [4]
17.1 c. The Effects of a Monetary Injection
The quantity theory of money is a theory about the demand for money in an economy. The most common version, sometimes called the “neo-quantity theory” or Fisherian theory, suggests there a mechanical and fixed proportional relationship between changes in the money supply and the general price level [5].
The Fisher equation is calculated as:
M x V = P x T
Where: M represents the money supply.
V represents the velocity of money.
P represents the average price level.
T represents the volume of transactions in the economy.
Generally speaking, the quantity theory of money assumes that increases in the quantity of money tend to create inflation, and vice versa [5].
Example: If the Federal Reserve or European Central Bank doubled the supply of money in the economy, the long-run prices in the economy would tend to increase dramatically [5].
Quantity Theory of Money [6]
17.1 d. The Classical Dichotomy and Monetary Neutrality
The view in classical economics and neoclassical economics that real variables in the economy are determined purely by real factors and not by monetary factors, and nominal variables are determined purely by monetary factors and not by real ones [7].
The neutrality of money, also called neutral money, says changes in the money supply only affect nominal variables and not real variables. In other words, an increase or decrease in the money supply can change the price level but not the output or structure of the economy [8].
Example: Suppose a macroeconomist is studying monetary policy from a central bank, such as the Federal Reserve. When the Fed engages in open market operations, the macroeconomist does not assume that changes in the money supply will change future capital equipment, employment levels or real wealth in long-run equilibrium. This gives the economist a much more stable set of predictive parameters [8].
Classical Dichotomy and Monetary Neutrality [9]
17.1 e. Velocity and the Quantity Equation
The velocity of money is the rate at which money is exchanged from one transaction to another and how much a unit of currency is used in a given period of time [10].
The equation of exchange is an economic equation that showcases the relationship between money supply, velocity of money, the price level and an index of expenditures [11].
The equation of exchange is as follows [11]:
M x V = P x T
Where:
M = money supply
V = velocity of money
P = average price level of goods
T = index of expenditures (such as the total number of economic transactions)
Example: An increase in the money supply should theoretically lead to a commensurate increase in prices because there is more money chasing the same level of goods and services in the economy. The opposite should happen with a decrease in money supply [10].
Velocity and the Equation of Exchange [12]
17.1 f. The Inflation Tax
Inflation tax is not an actual legal tax paid to a government; instead “inflation tax” refers to the penalty for holding cash at a time of high inflation [13].
Example: When the government prints more money or reduces interest rates, it floods the market with cash, which raises inflation in the long run. If a person is holding cash, though, this cash is worth less after inflation has risen [13].
Inflation Tax [14]
17.1 g. The Fisher Effect
The Fisher effect is an economic theory proposed by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher effect states that the real interest rate equals to the nominal interest rate minus the expected inflation rate [15].
Example: If the nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then the money in the savings account is really growing at 1% [15].
Fisher Effect [16]
