Chapter 7: Money and Inflation

1. Key issues in the chapter:

a. What causes inflation?

b. What are the effects of inflation?

c. What are the costs versus benefits of removing inflation?

2. What is money?

a. Defined according to its functions rather than its form.

b. Functions of money as a store of value, unit of account, and medium of exchange.

c. Commodity money (intrinsic value) versus fiat money.

d. How fiat money evolves

3. The supply of money.

a. How it is controlled. The role of the central bank (Fed)

b. How it is measured. C, M1, M2, M3

4. The demand for money. The quantity theory of money

a. Transactions and the quantity equation

b. From transactions to income

c. From the equation of exchange to the transactions demand for money

d. The assumption of constant velocity

e. The effect of money on the price level and inflation

5. Seigniorage: The revenue from printing money

a. Raising revenue from taxes, borrowing, or printing money

b. The inflation tax from additional money (lowering real value of money assets)

6. Inflation and Interest Rates

a. Real versus nominal interest rates

b. The Fisher Effect

c. Ex Ante versus Ex Post real interest rates, the role of expected inflation versus actual inflation

7. The Nominal Interest Rate and the Demand for Money

a. The cost of holding money

b. The general demand for money L(i,Y)

c. Supply and demand equilibrium M/Y = L(i,Y)

8. What causes inflation? The transmission mechanism between “too much” money compared with the rate of output of goods and services.

a. Portfolio adjustments

b. The role of expected inflation, nominal interest rates, and the velocity of money.

c. What is the right amount of money?

9. How to stop hyperinflation.

a. Nominal interest rates will fall with a decline in expected inflation.

b. The demand for money will rise with lower nominal interest rates, so that money velocity will fall.

c. Without new money, the inflation rate will subside, nominal interest rates will stabilize, and the demand for money will stabilize based upon real output.

d. An important ingredient is the credibility of the central bank in stabilizing growth in nominal money balances.

10. The social costs of inflation

a. Inflation as a tax on fixed earners

b. The effect on transactions costs and economizing on money balances.

c. Is a little inflation desirable to allow for relative price adjustments? The cost of menu price adjustments versus flexibility of relative prices.

d. How does inflation affect economic growth. Real versus nominal wages and real versus nominal interest rates.

e. The tax code and personal financial planning: the effect of unexpected inflation.

f. Higher inflation and volatile inflation are related. What about indexing?

11. Conclusion: The Classical Dichotomy

a. Real money balances affect real spending, output, and employment.

b. Money affects the price level, nominal interest rates and money wages, but not real interest rates nor real wages.

c. In the long-run the monetary neutrality in which money has no effect on real values is approximately correct.