ECON1102 Study Guide - Final Guide: Classical Dichotomy, Nominal Interest Rate, Real Interest Rate
Inflation
• Inflation is something affecting the money economy NOT the real economy.
• Changes in price, in effect, are irrelevant, simply changing the nominal (existing) value of goods and
services, not its actual value.
o Real - the economy of the physical world, where physical goods and services are produced and
consumed.
o Monetary economy - the circulation of money and other financial instruments throughout the
economy above and beyond that physical economy.
Classical Dichotomy
• One view of the broader relationships between real and money economies is the so-called classical
dichotomy which says that in the long run, the real and nominal sides of the economy are completely
separate. When all prices in the economy double, relative prices are unchanged. When the relative
prices of goods are unchanged, nothing real is affected.
• The neutrality of money follows from this, i.e. the proposition that changes in the money supply have
no real effects on the economy and only affect prices.
Is Money Neutral?
• Because classical and neoclassical thought holds that money is simply a device that facilitates real
exchange and that it has no effect on real quantities and prices, money is 'neutral' with respect to the
real economy in the long-run.
• Money is seen even in neoclassical thought to have short-run effects.
Is Inflation Neutral?
• At any given point in time, we can measure the price level.
• In the long-run, the inflation rate, i.e. rate of change in levels, is immaterial to the real economy. But in
the short-run, no.
Short-Run Costs of Inflation
• The classical/neoclassical model is a long-run model where adjustments are 'perfect'.
• But in the real short-run world, there are lags and rigidities and these can create problems for the real
economy.
• These rigidities thus make inflation important to manage from a policy point of view.
Costs of Inflation
Arbitrary
Redistributions
of Wealth
• One effect of nominal contract rigidity is that inflation can redistribute wealth and
income in way with no particular economic merit and which are driven purely by
changes in money prices in the short-run.
• Debtors benefit if they have fixed rate debt contracts with interest rates that do
not adjust for inflation. Of course lenders suffer.
• An individual who has a pension that is not indexed to inflation suffers as does a
bank that issues loans at fixed rates, but that pays interest rates that move with
the market.
• It takes time for money contracts to be changed and changes in the money
economy lead to misallocation of real resources.
Tax Distortions
• Along similar lines, inflation can also play havoc with tax systems, especially with
surprise rises in inflation and/or with a lack of adjustment of taxes by gov.
• 'Bracket creep' is a classic example of this. Progressive tax systems 'bracket'
categories of income and tax higher brackets more than lower ones.
"Shoe Leather"
(Transaction)
Costs
• Shoe leather costs refers to the opportunity cost of time and energy that people
spend trying to counter-act the effects of inflation, such as consumers holding less
cash and spending more frequently, suppliers editing price lists or menus
(referred to as menu costs, i.e. the costs to firms of changing prices frequently),
etc.
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