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Topic 21 - Inflation.pdf

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University of Toronto St. George
James Pesando

Topic 21 – Inflation th st March 16 – 21 Outline: 1. Money growth and inflation; 2. An Inflation Fallacy; 3. Redistributive Effect of (Unanticipated) Inflation; 4. Interest Rates and Inflation; 5. Why is inflation bad?  Money Growth and Inflation Inflation: the rate at which the price level is rising Key Result: In the long run, a change in money supply: -- Does not affect real GDP -- Affects only the price level; Long Run Neutrality of Money r MS 0 MS 1 1. Increase of money supply from MS to MS ,0driving 1nterest rate down from r to0r ; 1 r 0 2. Through transmission mechanism, AD shifts0to AD ; 1 r1’ 3. As a result, Real GDP increases to Y , and price level increases MD 1 r1 MD 2 to p1; 0 MD 1 quantity of money 4. Because Real GDP and price increases, demand for money increases; MD shifts up to MD ; i1terest rate increases to r ’; 1 P AS 5. Inflationary gap is present, wages and other factors increase, 1 shifting AS to AS (sefl-correction); p 1 2 AS 0 6. Y is adjusted back to Y P,th increased price P 2. p1 7. The higher price level further shifts MD up to MD , thus 2 p 0 AD 1 restoring the interest rate to its initial level,0r . AD 0 YP Y 1 Repeated increases in the money supply produce repeated increases in the price level and thus create inflation. Money Growth – Inflation Link Hyperinflations (greater than 1,000 percent per year) -- 25 countries have experienced (since 1980) -- In all cases inflation rate equals (approx.) money growth rate WHY?? Governments print money (rather than raise taxes or borrow) to finance spending; Inflation rate current: CA: 2.2% U.S. 2.1% China 4.9% India 8.1% Euro Area 2.1% Historical inflation rates in Canada 2001 to 2010 2.1% 1978 to 1982 10% Current inflation rates (temporarily) high because of high food, commodities (oil, etc) prices  An Inflation Fallacy The fallacy: “Inflation robs people of the purchasing power of their incomes.” Reality: If price level doubles (inflation of 100%) then incomes in total must double as well. Intuition: Expenditure = Income Mary pays John $20 to mow lawn Expenditure (Mary) = $20 = Incom
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