MODERN PRINCIPLES OF ECONOMICSFifth EditionChapter (33)

MODERN PRINCIPLES OF ECONOMICS
Fifth Edition
Chapter (33)
Transmission and
Amplification
Mechanisms
© 2021 Worth Publishers. All Rights Reserved.
Outline
• Intertemporal Substitution
• Uncertainty and Irreversible Investments
• Labor Adjustment Costs
• Time Bunching and Network Effects
• Collateral Damage
• Takeaway

Introduction (1 of 2)
• Economic forces can amplify shocks and transmit them
across sectors and through time.
• A mild negative shock can be transformed into a
serious reduction in output.
• A positive shock can be transformed into a boom.
• Real shocks and aggregate demand shocks can
interact, with one leading to the other.
• This chapter focuses on five transmission mechanisms:
1. Intertemporal substitution
2. Uncertainty and irreversible investments
3. Labor adjustment costs
4. Time bunching and network effects
5. Collateral damage

Intertemporal Substitution (1 of 4)
• People are most likely to work hard when hard work brings
the greatest return.
• As a test approaches, you probably study harder and give
up opportunities to have fun.
• Once the test is over, you study less and have more fun.
• During a boom, people are less likely to retire or take early
retirement.
• Substituting effort across time is called intertemporal
substitution.
Definition (1 of 6)
Intertemporal substitution:
The allocation of consumption, work, and leisure across
time to maximize well-being.
Intertemporal substitution: percentage deviation from trend in
GDP and the employment–population ratio, 1950–2010

• When there is a downturn, people work less and invest
less.
• The ripple effects turn an initial shock into a broader
recession.
• Intertemporal substitution can also feed an economic
boom and make it more intense.
Self-Check (1 of 3)
Intertemporal substitution of effort:
a. amplifies only positive shocks.
b. amplifies both positive and negative shocks.
c. dampens the effect of shocks.

Self-Check (1 of 3) (Answer)
Intertemporal substitution of effort:
a. amplifies only positive shocks.
b. amplifies both positive and negative shocks.
c. dampens the effect of shocks.
Answer:
b. Intertemporal substitution amplifies both positive and
negative shocks.
Irreversible Investments
• Many investments involve sunk costs—that is, they are
irreversible investments, or very costly to reverse.
• Once a building is built, it is difficult to redeploy the
materials to different economic uses.
• The more uncertain the world appears, the harder it is
for investors to read signals about where they should
invest.
• Uncertainty usually slows investment and keeps
resources in less productive uses.

Definition (2 of 6)
Irreversible investments:
Have high value only under specific conditions—they
cannot be easily moved, adjusted, or reversed if
conditions change.
Self-Check (2 of 3)
Investments involving sunk costs are called:
a. sunk investments.
b. intertemporal investments.
c. irreversible investments.
Investments involving sunk costs are called:
a. sunk investments.
b. intertemporal investments.

c. irreversible investments.
Answer:
c. Investments involving sunk costs are called irreversible
investments.
Labor Adjustment Costs
• Once a negative shock hits, workers must look for new jobs,
move to new areas, and sometimes change their wage
expectations.
• This induces more searching and thus causes more search-
related unemployment.
• The high cost of reversing job decisions can lead to
unemployment.
• When faced with uncertainty, many workers will wait,
increasing unemployment and magnifying the negative real
shock.
Definition (3 of 6)
Labor adjustment costs:
The costs of shifting workers from the declining sectors of

the economy to the growing sectors.
Time Bunching
• Many economic activities cluster in time because it
pays to coordinate your economic actions with those of
others.
• We want to invest, produce, and sell at the same time
as others.
• The clustering of economic activity in time makes
buying and selling more efficient.
• It also causes shocks to spread through the economy
and to spread through time.
Definition (4 of 6)
Time bunching:
The tendency for economic activities to be coordinated at
common points in time.
Collateral Damage (1 of 3)

• Banks are more concerned about downside risk
because if a customer does poorly, the bank could lose
the entire value of its loan.
• If the firm does incredibly well, the bank simply gets its
loan back plus interest.
• Banks don’t often invest in start-ups or firms with debts
that exceed assets.
• This behavior amplifies booms and busts for the
economy as a whole.
Definition (5 of 6)
Collateral:
A valuable asset that is pledged to a lender to secure a
loan. If the borrower defaults, ownership of the collateral
transfers to the lender.
Definition (6 of 6)
Collateral shock:
A reduction in the value of collateral. Collateral shocks
make borrowing and lending more difficult.

• During a boom, asset prices go up and firms have cash flow.
• Banks are willing to approve more loans, making the boom
even
bigger.
• In a downturn, asset prices fall, cash flow is reduced, and
firms
have lower net worth.
• Lenders see loans as being riskier, so they cut off or restrict
credit.
• This drives more firms under, increasing joblessness and
making
the bust worse.
• Real shocks and aggregate demand shocks can reinforce
and amplify each other.
• When the nominal owner of a property doesn’t have much
equity in the property, very often he or she doesn’t do a
good job of taking care of the property.
• When the bank itself is “underwater” or nearly so, the bank

managers don’t do a very good job of taking care of the
bank.
• The net result: When asset prices fall, there is a lot of
collateral damage.
Self-Check (3 of 3)
A reduction in the value of an asset pledged to a lender is
called:
a. a reversible investment.
b. collateral shock.
c. time bunching.
A reduction in the value of an asset pledged to a lender is
called:
a. a reversible investment.
b. collateral shock.
c. time bunching.

Answer:
b. A reduction in the value of an asset pledged to a
lender is called collateral shock.
Takeaway
• At least five factors amplify economic shocks:
1. Labor supply and intertemporal substitution
2. Uncertainty and irreversible investment
3. Labor adjustment costs
4. Time bunching and network effects
5. Collateral shocks
MODERN PRINCIPLES OF ECONOMICSOutlineIntroduction
(1 of 2)Introduction (2 of 2)Intertemporal Substitution (1 of
4)Definition (1 of 6)Intertemporal Substitution (2 of
4)Intertemporal Substitution (3 of 4)Intertemporal Substitution
(4 of 4)Self-Check (1 of 3)Self-Check (1 of 3)
(Answer)Irreversible InvestmentsDefinition (2 of 6)Self-Check
(2 of 3)Self-Check (2 of 3) (Answer)Labor Adjustment
CostsDefinition (3 of 6)Time BunchingDefinition (4 of
6)Collateral Damage (1 of 3)Definition (5 of 6)Definition (6 of
6)Collateral Damage (2 of 3)Collateral Damage (3 of 3)Self-
Check (3 of 3)Self-Check (3 of 3) (Answer)Takeaway

Fifth Edition
Chapter (32)
Business Fluctuations:
Aggregate Demand and
Supply
Outline
• The Aggregate Demand Curve
• The Long-Run Aggregate Supply Curve
• Real Shocks
• Aggregate Demand Shocks and the Short-Run Aggregate
Supply
Curve
• Shocks to the Components of Aggregate Demand
• Understanding the Great Depression: Aggregate Demand
Shocks
and Real Shocks
• Takeaway

• Economic growth is not a smooth process.
• Real GDP in the United States has grown at an
average rate of 3.2% per year over the past 65 years.
• The economy rarely grew at an average rate.
• Growth fluctuated from −5% to more than 8%.
• Recessions are of special concern to policymakers and
the public because unemployment typically increases
during them.
Definition (1 of 7)
Business fluctuations:
Fluctuations in the growth rate of real GDP around its
trend growth rate.
Recession:
A significant, widespread decline in real income and
employment.

Quarterly growth rate in real GDP, 1948–2019
U.S. civilian unemployment rate, 1948–2019
• To understand booms and recessions, we will develop
a model of aggregate demand and aggregate supply
(AD–AS), with three curves:
– Aggregate demand curve
– Long-run aggregate supply curve
– Short-run aggregate supply curve
• The AD–AS model shows how unexpected economic
disturbances or “shocks” can temporarily increase or
decrease the rate of growth.
Definition (2 of 7)
Aggregate demand curve:

Shows all the combinations of inflation and real growth
that are consistent with a specified rate of spending
growth:
+
M v
The Aggregate Demand Curve (1 of 4)
• We can derive the AD curve using the quantity theory of
money in dynamic form:
( )
+ = +
=
=
=
=

where :
Growth rate of the money supply
Growth in velocity
Growth rate of prices inflation
Growth rate of real GDP
R
R
M v P Y
M
v
p
Y
• We can also write the equation as:
growthRealInflationvM +=+
• Example: If money growth = 5%, velocity = 0%, and
real growth is 0%, the inflation rate = 5%.

• In other words, if the money supply is growing, velocity
is constant, and there are no additional goods, then
prices must go up.
• Another example: If money growth = 5%, velocity = 0%, and
real growth is 3%, the inflation rate = 2%.
• An AD curve tells us all the combinations of inflation and
real growth that are consistent with a specified rate of
spending growth:
+
M ν
• In our example, any combination of inflation and real
growth that adds up to 5% is on the same AD curve.
An AD curve with a slope of
–1 means a 1 percentage
point increase in real growth
reduces inflation by 1%.

Self-Check (1 of 5)
vM + equals:
a. Real growth.
b. Inflation + Nominal growth.
c. Inflation + Real growth.
vM + equals:
a. Real growth.
b. Inflation + Nominal growth.
c. Inflation + Real growth.
Answer:
c. growthRealInflationvM +=+
Shifts in Aggregate Demand Curve (1 of 2)

• Increased spending must flow into either a higher
inflation rate or a higher growth rate.
– If spending growth increases, because of either an
increase in money supply or an increase in velocity, then
the AD curve shifts up and to the right.
• A decrease in spending growth shifts the AD curve
inward.
Shifts in Aggregate Demand Curve (2 of 2)
Long-Run Aggregate Supply Curve (1 of 2)
• Every economy has a potential growth rate determined
by:
– Increases in the stocks of labor and capital
– Increases in productivity
• The rate of growth, as given by these real factors of
production, is called the Solow growth rate.
• The long-run aggregate supply curve is a vertical line
at the Solow growth rate, independent of the inflation
rate.

Long-Run Aggregate Supply Curve (2 of 2)
Potential growth does
not depend on the rate
of inflation.
Definition (3 of 7)
Solow growth rate:
An economy’s potential growth rate; the rate of economic
growth that would occur given flexible prices and the
existing real factors of production.
Long-run aggregate supply curve (LRAS):
Is vertical at the Solow growth rate.
Self-Check (2 of 5)
An economy’s potential growth rate is called the:
a. Solow growth rate.
b. aggregate supply.
c. aggregate demand.

An economy’s potential growth rate is called the:
a. Solow growth rate.
b. aggregate supply.
c. aggregate demand.
Answer:
a. An economy’s potential growth rate is called the Solow
growth rate.
Shifts in the LRAS Curve (1 of 2)
• When we put the AD and LRAS curves together, we
can see how business fluctuations are caused by real
shocks.
• In this model, the equilibrium inflation rate and the
growth rate are determined by the intersection of the
AD and LRAS curves.

AD and LRAS Curves (1 of 2)
If ν+M is 10% and real
growth is 3%, then the
inflation rate will be 7%.
Shifts in the LRAS Curve (2 of 2)
• Economies are continually hit by real shocks, which
shifts the Solow growth rate.
• Real shocks are rapid changes in economic conditions
that increase or diminish the productivity of capital and
labor.
• This, in turn, influences GDP and employment.
• Possible shocks include wars, weather, major new
regulations, tax rate changes, mass strikes, terrorist
attacks, and new technologies.
AD and LRAS Curves (2 of 2)

Real Shocks (1 of 2)
• Agriculture has been the largest contributor to India’s
GDP.
• If farmers struggle, many other sectors suffer.
• Weather shocks influence both agricultural output and
GDP.
• As the Indian economy has grown and diversified,
shocks due to the weather become less economically
important.
Real Shocks: Weather
Real Shocks: Oil (1 of 3)
• In an economy with a large manufacturing sector, a
reduction in the oil supply reduces GDP.
• Oil and machines are complementary: They work
together with labor to produce output.
• When the oil supply is reduced, capital and labor
become less productive.

• The first OPEC oil shock came in late 1973, and the
price of oil more than tripled in two years.
• Since oil is an important input in many sectors, high oil
prices—or oil shocks—hurt many American industries.
• In each of the last six U.S. recessions, there was a
large increase in the price of oil just prior to or
coincident with the onset of recession.
• A 10% increase in the price of oil lowers the GDP
growth rate for a little more than two years.
The price of oil and U.S. recessions
Real Shocks (2 of 2)
Negative Shocks = LRAS Curve Moves
Left

Positive Shocks = LRAS Curve Moves
Right
Bad weather (important in agricultural
economy)
Good weather (important in agricultural
economy)
Higher price of oil or another important
input
Lower price of oil or another important
input
Productivity slump/technology slump Productivity
boom/technology boom
Higher taxes or regulation Lower taxes or regulation
Disruption of production by war,
earthquake, or pandemic
Smooth production without disruption
Self-Check (3 of 5)
Higher business taxes will shift the long-run aggregate
supply curve:
a. to the left.

b. to the right.
c. Higher taxes will not shift the LRAS curve.
Higher business taxes will shift the long-run aggregate
supply curve:
a. to the left.
b. to the right.
c. Higher taxes will not shift the LRAS curve.
Answer:
a. Higher business taxes will decrease the LRAS curve,
shifting it to the left.
Aggregate Demand Shocks (1 of 2)
In his book The General Theory of
Employment, Interest and Money,
John Maynard Keynes explained that
when prices are not perfectly flexible,
deficiencies in aggregate demand can
generate recessions.

John Maynard Keynes
Definition (4 of 7)
Short-run aggregate supply (SRAS) curve:
Shows the positive relationship between the inflation rate
and real growth during the period when prices and wages
are sticky.
Short-Run Aggregate Supply Curve
• The SRAS curve is upward sloping.
• In the short run, an increase in AD will increase both
inflation and the growth rate.
• In the short run, a decrease in AD will decrease both
the inflation rate and the growth rate.
• Each SRAS curve is associated with a particular rate of
expected inflation E(π).
Short-Run Aggregate Supply

Definition (5 of 7)
Aggregate demand shock:
A rapid and unexpected shift in the AD curve (spending).
Aggregate Demand Shocks (2 of 2)
• A positive shock to spending must increase either
inflation or the real growth rate.
• In the short run, an increase in spending will be split
between increases in inflation and increases in real
growth.
• In the long run, the real growth rate is equal to the
Solow rate, which is not influenced by inflation.
• In the long run, therefore, an increase in spending will
increase only the inflation rate.
An Increase in Aggregate Demand (1 of 3)
If there is an

unexpected ↑ in
,M
both inflation and the
growth rate increase in
the short run (a → b).
• Workers initially mistake a nominal wage increase for a real
wage increase.
• Prices also don’t move instantly because it is costly to
change prices (“menu costs”).
• Firms may also hold off on making price changes because
they are not sure whether the change in market conditions
is temporary or permanent.
• As prices increase throughout the economy, workers
demand even higher wages to catch up to the higher
inflation rate.
Definition (6 of 7)
Menu costs:

The costs of changing prices.
Definition (7 of 7)
Nominal wage confusion:
Occurs when workers respond to their nominal wage
instead of to their real wage—that is, when workers
respond to the wage number on their paychecks rather
than to what their wage can buy in goods and services
(the wage after correcting for inflation).
Eventually, inflation
expectations adjust,
wages become unstuck,
and the growth rate
returns to the Solow rate
(b → c).
Self-Check (4 of 5)
The costs associated with changing the prices of goods
and services are called:

a. inflation costs.
b. inflationary expectations.
c. menu costs.
The costs associated with changing the prices of goods
and services are called:
a. inflation costs.
b. inflationary expectations.
c. menu costs.
Answer:
c. Menu costs are associated with changing the prices of
goods and services.
A Decrease in Aggregate Demand (1 of 3)
• When aggregate demand (AD) falls due to a fall in the
money supply:
– The economy shifts to a new short-run equilibrium point.

– The inflation rate is reduced.
– Real growth is reduced (recession).
• Prices and wages are especially sticky in the
downward direction.
• It can take the economy a long time to move out of a
recession.
A decrease in AD
can induce a lengthy
recession.
Shocks to Components of AD
v :
• Are the same as changes in the spending rate, holding
M constant

• Can be broken down into changes in the growth rate of C, I,
G, or NX
• Changes in tend to be temporary.
v
• The shares of GDP devoted to C, I, G, and NX have been
quite stable over time.
A Shock to the Growth Rate of Spending
Factors That Shift AD
Positive Shocks (Increase AD) (= Higher
Growth Rate of Spending)
Negative Shocks (Decrease AD) (= Lower
Growth Rate of Spending)
A faster money growth rate A slower money growth rate
Confidence Fear
Increased wealth Reduced wealth
Lower taxes Higher taxes

Greater growth of government spending Lower growth of
government spending
Increased export growth Decreased export growth
Decreased import growth Increased import growth
Self-Check (5 of 5)
A slower growth in the money supply will:
a. decrease AD.
b. increase AD.
c. not affect AD.
A slower growth in the money supply will:
a. decrease AD.
b. increase AD.
c. not affect AD.

Answer:
a. A slower growth in the money supply will decrease AD.
The Great Depression (1 of 6)
• The Great Depression was due primarily to a large fall in
AD.
• In 1929, the U.S. stock market crashed.
• People felt poorer and decreased spending, reducing AD.
• In 1930, depositors lost confidence in their banks.
• From 1930 to 1932, there were four waves of banking
panics.
• By 1933, more than 40% of American banks had failed.
• The fear and uncertainty also reduced investment
spending.
• The U.S. capital stock was lower in 1940 than it had
been in 1930.

• In 1931, instead of increasing the money supply to
boost the economy, the Federal Reserve allowed the
money supply to contract even further.
• Additional monetary contraction occurred from 1937 to
1938, prolonging the Great Depression.
• During the early 1930s, the U.S. money supply fell by
about one-third, the largest negative shock to
aggregate demand in American history.
• Real shocks also played a role in the Great Depression.
• Bank failures not only reduced the money supply and
spending (AD shock), but also reduced the efficiency of
financial intermediation.
• Economic policy mistakes also impeded recovery;

government agencies tried to increase prices by reducing
supply.
• The Smoot–Hawley Tariff of 1930 raised tariffs on imports;
other countries retaliated.
• A severe drought and decades of ecologically
unsustainable farming practices turned millions of
acres of farmland into a “dust bowl.”
• The shocks compounded one another and made
a desperate situation even worse.
Takeaway (1 of 2)
• The aggregate demand and supply model can be used
to analyze fluctuations in the growth rate of real GDP.
• Real shocks are analyzed through shifts in the LRAS
curve, while aggregate demand shocks are analyzed
using shifts in the AD curve.
• Nominal wage and price confusion, sticky wages and
prices, menu costs, and uncertainty create an upward-
sloping short-run aggregate supply curve.

Takeaway (2 of 2)
• The Great Depression resulted from an unfortunate,
concentrated, and interrelated series of aggregate
demand and real shocks.
• It can be illustrated using the AD–AS model.
MODERN PRINCIPLES OF ECONOMICSOutlineIntroduction
(1 of 4)Definition (1 of 7)Introduction (2 of 4)Introduction (3 of
4)Introduction (4 of 4)Definition (2 of 7)The Aggregate
Demand Curve (1 of 4)The Aggregate Demand Curve (2 of
4)The Aggregate Demand Curve (3 of 4)The Aggregate Demand
Curve (4 of 4)Self-Check (1 of 5)Self-Check (1 of 5)
(Answer)Shifts in Aggregate Demand Curve (1 of 2)Shifts in
Aggregate Demand Curve (2 of 2)Long-Run Aggregate Supply
Curve (1 of 2)Long-Run Aggregate Supply Curve (2 of
2)Definition (3 of 7)Self-Check (2 of 5)Self-Check (2 of 5)
(Answer)Shifts in the LRAS Curve (1 of 2)AD and LRAS
Curves (1 of 2)Shifts in the LRAS Curve (2 of 2)AD and LRAS
Curves (2 of 2)Real Shocks (1 of 2)Real Shocks: WeatherReal
Shocks: Oil (1 of 3)Real Shocks: Oil (2 of 3)Real Shocks: Oil
(3 of 3)Real Shocks (2 of 2)Self-Check (3 of 5)Self-Check (3 of
5) (Answer)Aggregate Demand Shocks (1 of 2)Definition (4 of
7)Short-Run Aggregate Supply CurveShort-Run Aggregate
SupplyDefinition (5 of 7)Aggregate Demand Shocks (2 of 2)An
Increase in Aggregate Demand (1 of 3)An Increase in Aggregate
Demand (2 of 3)Definition (6 of 7)Definition (7 of 7)An
Increase in Aggregate Demand (3 of 3)Self-Check (4 of 5)Self-
Check (4 of 5) (Answer)A Decrease in Aggregate Demand (1 of
3)A Decrease in Aggregate Demand (2 of 3)A Decrease in
Aggregate Demand (3 of 3)Shocks to Components of ADA
Shock to the Growth Rate of SpendingFactors That Shift

ADSelf-Check (5 of 5)Self-Check (5 of 5) (Answer)The Great
Depression (1 of 6)The Great Depression (2 of 6)The Great
Depression (3 of 6)The Great Depression (4 of 6)The Great
Depression (5 of 6)The Great Depression (6 of 6)Takeaway (1
of 2)Takeaway (2 of 2)
Fifth Edition
Chapter 12 (31)
Inflation and the
Quantity Theory of
Money
Outline
• Defining and Measuring Inflation
• The Quantity Theory of Money
• The Costs of Inflation
• Takeaway

Introduction
• Zimbabwe President Robert Mugabe’s policy of seizing
commercial farms drove away entrepreneurs and
investors.
• To bribe his enemies and pay the army, he simply
printed more money.
• The economy was flooded with money but could not
produce more goods.
• Prices went up: The inflation rate increased from 50%
per year to 50% per month to more than 50% per day.
Definition (1 of 8)
Inflation:
An increase in the average level of prices.
Inflation (1 of 4)
• Inflation is measured by changes in a price index.
• The inflation rate is the percentage change in a price
index from one year to the next.

100rate Inflation
1
12 ×
−
=
P
PP
where P2 is the index value in year 2 and P1 is the
index value in year 1.
Inflation (2 of 4)
Self-Check (1 of 5)
If the price index is 200 in year 1 and 210 in year 2, the
rate of inflation is:
a. 4.76%.
b. 5%.
c. 20%.

If the price index is 200 in year 1 and 210 in year 2, the
rate of inflation is:
a. 4.76%.
b. 5%.
c. 20%.
Answer:
b. The rate of inflation is (210 – 200) / 200 × 100 = 5%.
Price Indexes
1. Consumer price index (CPI): Measures the average
price for a basket of goods and services bought by a
typical American consumer; covers 80,000 goods and
services and is weighted so major items count more.
2. GDP deflator: The ratio of nominal to real GDP
multiplied by 100; covers finished goods and services.
3. Producer price indexes (PPI): Measure the average
price received by producers; includes intermediate and
finished goods and services.

Relevance of CPI as a Price Index
• For Americans, CPI is the measure of inflation that
corresponds most directly to their daily economic
activity.
• The Bureau of Labor Statistics (BLS) computes the
CPI.
• It tries to take both new goods and higher-quality goods
into account when computing the CPI.
Inflation (3 of 4)
Effect of Inflation on Price
The cumulative effect of inflation on a large basket of goods
Definition (2 of 8)

Real price:
A price that has been corrected for inflation. Real prices
are used to compare the prices of goods over time.
Real Prices
• The CPI is used to calculate real prices.
1982 2006
Gallon of gasoline $1.25 $2.50
CPI 100 202
$2.53
100
202 $1.25 =×
• The real price of gasoline (adjusted for inflation) was
slightly lower in 2006 than it was in 1982.
Inflation (4 of 4)
Inflation rate in selected
countries
• In 2016, South Sudan and
Venezuela had the highest

inflation rates in the world,
approaching 500%.
• Italy, Greece, and Japan had
slight deflations.
Country 2016
South Sudan 476.02
Venezuela 475.806
Suriname 67.109
Angola 33.683
Malawi 19.782
Brazil 9.019
Mexico 2.824
China 2.075
United States 1.188
United Kingdom 0.743
Germany 0.399
France 0.346
Netherlands 0.103
Italy −0.05

Greece −0.1
Japan −0.162
Hyperinflation
• Hyperinflation occurs when price increases are so out
of control that the concept of inflation is meaningless.
Hungary’s post-war hyperinflation is the largest on
record.
Nation Period Cumulative Inflation Rate (%) Maximum
Inflation Rate on a Monthly Basis (%)
America 1777–1780 2,702 1,342
Bolivia 1984–1985 97,282 196
Peru 1987–1992 17,991,287 1,031
Yugoslavia 1993–1994 1.6 × 109 5 × 1015
Nicaragua 1986–1991 1.2 × 1010 261
Greece 1941–1944 1.60 × 1011 8.5 × 109
Germany 1919–1923 0.5 × 1012 3,250,000
Zimbabwe 2001–2008 8.53 × 1023 7.96 × 1010
Hungary 1945–1946 1.3 × 1024 4.19 × 1016

Self-Check (2 of 5)
A real price is a price that has been corrected for:
a. population growth.
b. foreign currency exchange rates.
c. inflation.
A real price is a price that has been corrected for:
a. population growth.
b. foreign currency exchange rates.
c. inflation.
Answer:
c. A real price is a price that has been corrected for
inflation.

Quantity Theory of Money (1 of 5)
The quantity theory of money
• Sets out the general relationship between money,
velocity, real output, and prices
• Helps to explain the critical role of the money supply in
determining the inflation rate
Mv = PYR
where: M = Money supply
P = Price level
v = Velocity of money
YR = Real GDP
• Since Mv is the total amount spent on finished goods
and services, and PYR is the the price level times real
GDP, both sides of this equation are also equal to
nominal GDP.
Definition (3 of 8)
Velocity of money (v):

The average number of times a dollar is spent on finished
goods and services in a year. In short, it refers to how fast
money passes from one holder to the next.
• We assume that both real GDP (YR) and velocity (v)
are stable compared to the money supply (M).
– Real GDP is fixed by the real factors of production:
capital, labor, and technology.
– The velocity of money is determined by factors that
change only slowly, such as how often workers are paid,
or how long it takes to clear a check.
– In the United States, the velocity of money is about 7.
The quantity theory of money in a nutshell
When v and Y are fixed (indicated by the top bar),
increases in M must cause increases in P.

Self-Check (3 of 5)
The number of times a dollar is spent on final goods and
services in a year is called:
a. the quantity theory of money.
b. the velocity of money.
c. the currency turnover rate.
The number of times a dollar is spent on final goods and
services in a year is called:
a. the quantity theory of money.
b. the velocity of money.
c. the currency turnover rate.
Answer:
b. The velocity of money is the number of times a dollar
is spent on final goods and services in a year.

The Cause of Inflation (1 of 3)
“Inflation is always and everywhere a monetary
phenomenon.”
Milton Friedman, 1912–2006
• If YR is fixed by the real factors of production and v is
stable, then the only thing that can cause an increase
in P is an increase in M.
– In other words, inflation is caused by an increase in the
supply of money.
• The quantity theory of money also says that the growth
rate of the money supply will be approximately equal to
the inflation rate.
• Nations with rapidly (slowly) growing money supplies had
high (low)
inflation rates.
• As indicated by the red line, on average the relationship is
almost

perfectly linear, with a 10% increase in the money growth rate
leading
to a 10% increase in the inflation rate.
• “Inflation is always and everywhere a monetary phenomenon.”
Definition (4 of 8)
Deflation:
A decrease in the average level of prices (a negative
inflation rate).
Disinflation:
A reduction in the inflation rate.
• An unexpected increase in the money supply can boost
the economy in the short run.
• As firms and workers come to expect and adjust to the
new influx of money, output will not grow any faster
than normal.
• In the long run, money is neutral.

The Costs of Inflation
• Four problems associated with inflation:
1. There is price confusion and money illusion.
2. Inflation redistributes wealth.
3. Inflation interacts with other taxes.
4. Inflation is painful to stop.
Price Confusion and Money Illusion
• Inflation makes price signals more difficult to interpret.
• It is not always clear whether prices are rising because
of increased demand or because of an increase in the
money supply.
• We sometimes mistake inflation for higher wages and
prices in real terms.
• Resources are wasted in activities that appear
profitable but are not, and resources flow more slowly
to profitable uses.
Definition (5 of 8)
Money illusion:

When people mistake changes in nominal prices for
changes in real prices.
Inflation Redistributes Wealth (1 of 6)
• Inflation is a type of tax that transfers real resources
from citizens to the government.
• Inflation reduces the real return that lenders receive on
loans, transferring wealth from lenders to borrowers.
• When inflation and interest rates fall unexpectedly,
wealth is redistributed from borrowers (who are paying
higher rates) to lenders.
Self-Check (4 of 5)
A decrease in the average level of prices is called:
a. deflation.
b. disinflation.
c. money illusion.

A decrease in the average level of prices is called:
a. deflation.
b. disinflation.
c. money illusion.
Answer:
a. A decrease in the average level of prices is called
deflation.
Definition (6 of 8)
Real rate of return:
The nominal rate of return minus the inflation rate.
Nominal rate of return:
The rate of return that does not account for inflation.
• The relationship between the lender’s real rate of
return, the nominal rate of return, and the inflation rate,

is:
Real
Real
-
where:
r Real interest rate
Nominal rate of interest
Rate of inflation
r i
i
π
π
=
=
=
=
• The real rate of return is equal to the nominal rate of
return minus the inflation rate.
Definition (7 of 8)

Fisher effect:
The tendency of nominal interest rates to rise with
expected inflation rates.
• When lenders expect inflation to increase, they will
demand a higher nominal interest rate.
• The Fisher effect says that the nominal interest rate is
equal to the expected inflation rate plus the equilibrium
real interest rate.
• It also says the nominal rate will rise with expected
inflation.
• The Fisher effect:
Equilibrium
π
where:
Equilibrium real rate of return
Nominal rate of interest

E Expected rate of inflation
i E r
r
i
π
= +
=
=
=
Equilibrium
The Fisher Effect
Nominal interest rates tend to increase with inflation rates.
Unexpected Inflation
(Eπ < π)
Unexpected Disinflation
(Eπ > π)

Expected Inflation = Actual Inflation
(Eπ = π)
Real rate less than
equilibrium rate
Real rate greater than
equilibrium rate
Real rate equal to equilibrium rate
Harms lenders
Benefits borrowers
Benefits lenders
Harms borrowers
No redistribution of wealth
Definition (8 of 8)
Monetizing the debt:
When the government pays off its debts by printing
money.

• A government with massive debts has an incentive to
increase the money supply, since it benefits from
unexpected inflation.
• The government doesn’t always inflate its debt away
for two reasons:
– If lenders expect inflation, they will increase nominal
rates.
– Buyers of bonds are often also voters, who would be
upset if real returns were shrunk.
Self-Check (5 of 5)
A government monetizes its debt by:
a. raising interest rates.
b. lowering interest rates.
c. printing money to pay off the debt.
A government monetizes its debt by:
a. raising interest rates.

b. lowering interest rates.
c. printing money to pay off the debt.
Answer:
c. A government monetizes its debt by printing money to
pay off the debt.
Breakdown of Financial Intermediation
(1 of 2)
• When nominal interest rates are not allowed to rise and
the inflation rate is high, the real rate of return will be
negative.
• People take their money out of the banking system.
• The supply of savings falls, and financial intermediation
becomes less efficient.
• Negative real interest rates reduce financial
intermediation and economic growth.
Breakdown of Financial Intermediation
(2 of 2)

• When inflation is volatile and unpredictable, long-term
loans become riskier.
• Few long-term contracts will be signed.
• Any contract involving future payments will be affected
by inflation.
Inflation Interacts with Other Taxes
• Most tax systems define incomes, profits, and capital
gains in nominal terms.
• Inflation will produce some tax burdens and liabilities
that do not make economic sense.
• If asset prices rise due to inflation, people pay capital
gains taxes when they should not.
• Inflation can push people into higher tax brackets.
• Corporations pay taxes on phantom profits.
Inflation Is Painful to Stop
• The government can reduce inflation by reducing the
growth in the money supply.

• When inflation is expected, lower inflation may be
misinterpreted as a reduction in demand.
• Firms reduce output and employment.
• Workers may become unemployed as the unexpected
increase in their real wage makes them unaffordable.
• Expectations will eventually adjust in the long run.
Takeaway (1 of 2)
• Inflation is an increase in the average level of prices as
measured by a price index.
• Sustained inflation is always and everywhere a
monetary phenomenon.
• Although money is neutral in the long run, changes in
the money supply can influence real GDP in the short
run.
• Inflation makes price signals more difficult to interpret.
Takeaway (2 of 2)
• The tendency of the nominal interest rate to increase
with expected inflation is called the Fisher effect.

• Arbitrary redistributions of wealth make lending and
borrowing riskier and thus break down financial
intermediation.
• Anything above a mild rate of inflation is generally bad
for an economy.
MODERN PRINCIPLES OF
ECONOMICSOutlineIntroductionDefinition (1 of 8)Inflation (1
of 4)Inflation (2 of 4)Self-Check (1 of 5)Self-Check (1 of 5)
(Answer)Price IndexesRelevance of CPI as a Price
IndexInflation (3 of 4)Effect of Inflation on PriceDefinition (2
of 8)Real PricesInflation (4 of 4)HyperinflationSelf-Check (2 of
5)Self-Check (2 of 5) (Answer)Quantity Theory of Money (1 of
5)Quantity Theory of Money (2 of 5)Definition (3 of 8)Quantity
Theory of Money (3 of 5)Quantity Theory of Money (4 of
5)Self-Check (3 of 5)Self-Check (3 of 5) (Answer)The Cause of
Inflation (1 of 3)Quantity Theory of Money (5 of 5)The Cause
of Inflation (2 of 3)Definition (4 of 8)The Cause of Inflation (3
of 3)The Costs of InflationPrice Confusion and Money
IllusionDefinition (5 of 8)Inflation Redistributes Wealth (1 of
6)Self-Check (4 of 5)Self-Check (4 of 5) (Answer)Definition (6
of 8)Inflation Redistributes Wealth (2 of 6)Definition (7 of
8)Inflation Redistributes Wealth (3 of 6)Inflation Redistributes
Wealth (4 of 6)The Fisher EffectInflation Redistributes Wealth
(5 of 6)Definition (8 of 8)Inflation Redistributes Wealth (6 of
6)Self-Check (5 of 5)Self-Check (5 of 5) (Answer)Breakdown
of Financial Intermediation (1 of 2)Breakdown of Financial
Intermediation (2 of 2)Inflation Interacts with Other
TaxesInflation Is Painful to StopTakeaway (1 of 2)Takeaway (2
of 2)

MODERN PRINCIPLES OF ECONOMICSFifth EditionChapter (33)

MODERN PRINCIPLES OF ECONOMICSFifth EditionChapter (33)

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