chapter 11: inflation. inflation a continuous rise of the general price level general price level is...
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Chapter 11: Inflation Chapter 11: Inflation
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Inflation
A continuous rise of the general price level
General price level is measured by the Consumer Price Index (CPI): The weighted average price of 400 goods & services sold in urban areas around the nation.
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Inflation RatePercentage change of the CPI over the previous period
Inflation stayed under 5% during the 1960s
It averaged 7.7% in the first half and 10.6% in the second half of the 1970s
Since the early 1980s, inflation rate has declined to as low as 3% in the late 1990s
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Demand-Pull Inflation
Inflation caused by an increase in the level of Aggregate Demand (1960s)
At full employment, expansion of the Aggregate Demand is inflationary with no additional output
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Price Level
Output of Goods & Services
105
110
200 400
S
S
D1
D1
Full employment output
120D2
D2
D3
D3
Demand-Pull Inflation
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Cost-Push InflationCost-Push Inflation
Inflation caused by an decrease in the level of Aggregate Supply (1970s & early 1980s)
Higher general price level and falling output of goods & services result in stagflation, inflation plus stagnation
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Cost-Push InflationPrice Level
Output of Goods & Services
105
110
200 400
S1
S
D
D
Full employment outputS2
115
50
S3
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Effects of Inflation
Equity effect: changing the pattern of income distribution from wage-earners to profit-makers
Efficiency effect: requiring greater investment in hedging against inflation in labor & business contracts
Output effect: recession resulting from cost-push inflation
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Functions of Money
Medium of ExchangeMeasure of ValueStore of Value
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Characteristics of Money
Limited in supplyWidely acceptedPortableDivisibleUniformDurable
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Money Supply
Narrow definition: M1
– Currency: coins & bills (25%)– Demand Deposits: checking account
deposits (75%)
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Money Supply
Broad definition: M2
– M1– Time Deposits: savings account deposits
(less than $100,000)
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Money Supply Line
The quantity of money in circulation is controlled by the central bank
Quantity of Money
Interest Rate (%)
S
S
80
5
10
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Money Demand
The amount of money demanded for transaction and speculative purposes depends: personal income and interest rate
At any level of personal income, quantity demanded of money is a negative function of interest rate
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Money Demand Line
Quantity of Money
Interest Rate (%)
D
D
10
5
10080
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Money Market Equilibrium
Quantity of Money
Interest Rate (%)
D
D
5
80
S
S
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Federal Reserve System, FED
The central bank of the U.S.
Independent decision making unit with regional banks
In charge of money supply management and economic stabilization
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Tools of Monetary Policy
Legal reserve ratio: ratio of cash reserves to deposits that banks are required to maintain
By lowering the ratio, banks will have more reserves to lend and invest, increasing the money supply
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Tools of Monetary Policy
Discount rate: rate of interest the FED charges on loans to banks
By lowering the rate, banks encourage borrowing from the FED and lending to the public, increasing the money supply
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Tools of Monetary Policy
Open Market Operations: FED’s purchases and sales of government bonds
By purchasing bonds and paying the sellers, the FED increases the money supply
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Expansionary Monetary Policy
Increase the money supply by any one or combination of the above tools
Reduce the interest rate to encourage investment
Increase Aggregate Demand, creating employment & income
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Expansionary Monetary Policy
Quantity of Money
Interest Rate (%)
D
D
5
80
S
S
S’
S’
4
85
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Quantity Theory of Money
Equation of Exchange: MV = PQ
– M = money supply– V = income velocity of money: the rate of turn over of
money– P = general price level– Q = output of goods & services
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Quantity Theory of Money
Write: P = (V/Q) M
Assuming V, Q, and V/Q constant, an increase in M causes a proportional increase in P
Inflation is caused by a rapid growth of the money supply
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Money Supply Growth & Inflation
In 1960s, inflation was low and money supply growth constant at about 7%
In the 1970s, inflation rose as the money supply grew at an increasing arte to reach 10%
In the 1980s and 1990s, inflation fell as money supply grew at a declining rate to reach about 6%