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Chapter 11: Inflation

Chapter 11: Inflation. 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. Inflation Rate.

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Chapter 11: Inflation

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  1. Chapter 11: Inflation

  2. 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.

  3. Inflation Rate • Percentage 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

  4. 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

  5. Demand-Pull Inflation Price Level D3 S D2 120 D1 110 D3 105 D2 Full employment output S D1 200 400 Output of Goods & Services

  6. Cost-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

  7. Cost-Push Inflation Price Level S S3 115 D 110 105 S2 Full employment output S1 D 50 200 400 Output of Goods & Services

  8. 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

  9. Functions of Money • Medium of Exchange • Measure of Value • Store of Value

  10. Characteristics of Money • Limited in supply • Widely accepted • Portable • Divisible • Uniform • Durable

  11. Money Supply • Narrow definition: M1 • Currency: coins & bills (25%) • Demand Deposits: checking account deposits (75%)

  12. Money Supply • Broad definition: M2 • M1 • Time Deposits: savings account deposits (less than $100,000)

  13. Money Supply Line • The quantity of money in circulation is controlled by the central bank Interest Rate (%) S 10 5 S 80 Quantity of Money

  14. 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

  15. Money Demand Line Interest Rate (%) D 10 5 D 100 80 Quantity of Money

  16. Money Market Equilibrium Interest Rate (%) S D 5 D S 80 Quantity of Money

  17. 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

  18. 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

  19. 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

  20. 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

  21. 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

  22. Expansionary Monetary Policy Interest Rate (%) S S’ D 5 4 D S S’ 85 80 Quantity of Money

  23. 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

  24. 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 Quantity Theory of Money

  25. 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%

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