Inflation SFLS types

Inflation
(Part 2 – Causes and theory
of the quantity of money)

2.) CPI – measuring Inflation
Inflation:
4.) Causes of Inflation
1.) Inflation Vocabulary
5.) Consequences of Inflation
3.) Problems of CPI
Part 1
Part 2
Part 3

3.) Demand-Pull
2.) Cost-Push
1.) Monetary *** A warning about inflation. In
the real world, inflation is
complex, and it’s causes are often
complex. Usually it’s not just one
reason that in happens like the
ones listed above, but many, so
many that economists constantly
disagree about the actual
reasons.

1.) Monetary
Government printing too much
money.
Easy Definition:
Textbook Definition:
The money supply is growing
faster then the increase in the
level of output in an economy
and forcing up prices.

Different parts of this theory that brings us to the conclusions we will work with:
Classical Dichotomy
Quantity Theory of Money
Neutrality of Money
Velocity of Money
(Q of Money)
(N of Money)
(V of Money)
2.1) Classical Theory
Remember this? Now we will
explore it all a little deeper to
explain the greater theory of the
quantity of money.

Classical Dichotomy
Neutrality of Money
Velocity of Money
(Q of Money) - The quantity of
money determines the
value of money.
Here, we will analyze the theory behind it with two approaches:
1.) An equation
2.) A money supply-demand diagram

Classical Dichotomy
Neutrality of Money
Velocity of Money
(N of Money) - In the long run, the overall
price level adjusts to the
level at which the demand
for money equals the
supply of money.
(nominal changes don’t affect real changes)
This is the conclusion of all
this theory that explains long
run inflation.

Classical Dichotomy
Neutrality of Money
Velocity of Money (V of Money) - the rate at which money
changes hands.
v =
P x Y
M
Equation:
P x Y = (price level) x (real GDP)
M = money supply
V = velocity

Households
Firms
G & S
markets
Demand stuff
Supply stuff
pay
money
earn
income
F & P
markets
Demand stuff
Supply stuff
earn
income
pay
money
Government
transferstaxes
taxessubsidies
Demand
stuff
Demand
stuffOther
Countries
Imports
Exports
The idea is that a single piece of
money gets used over and over in
this circular flow and the idea of
“Velocity” is trying to understand
how many times a single piece of
money gets used over and over.

Velocity of Money (V of Money)
v =
P x Y
M
Example with one good:比萨.
Y = real GDP = 5000比萨
P = price level = price of比萨 = 100元
P x Y = value of 比萨 = 500,000元
M = money supply = 100,000元
V = velocity = 500,000/100,000 = 5
The average yuan was used in 5 transactions.

Quantity Theory of Money (Q of Money) - The quantity of
value of money.
1.) Quantity Equation
or
Fisher Equation
v =
P x Y
M
Multiply both sides of formula by M:
M x V = P x Y=
Velocity of Money (V of Money)

The Quantity Theory in 5 Steps:
1.) V is stable.
2.) So, a change in M causes nominal GDP (P x Y)
to change by the same percentage.
3.) A change in M does not affect Y:
money is neutral,
Y is determined by technology & resources
4.) So, P changes by same percentage as
P x Y and M.
5.) Rapid money supply growth causes rapid inflation.
Start with 1.) quantity equation:
M x V = P x Y

Long Run Aggregate
Supply (LRAS)
Price
level
GDP
LRAS
Y
P1
P2Therefore: With the 1.) quantity
equation (fisher equation) if V is
stable that means an increase in
M just means and increase in P
and not Y, so in the long run we
just have inflation only.
M x V = P x Y
Inflation and the Classical Theory

Classical Dichotomy
Neutrality of Money
Velocity of Money
(Q of Money) - The quantity of
value of money.
Here, we will analyze the theory behind it with two approaches:
1.) An equation
2.)A money supply-demand diagram

Value of
Money, 1/P
Price
Level, P
Quantity of
Money
1 1
¾ 1.33
½ 2
¼ 4
As the value of
money rises, the
price level falls.
2.) Money supply – demand diagram

- is the relationship between the
quantity of money supplied and
the nominal interest rate.
The Supply of
Money
(MS)
- It is controlled by banks and is
fixed at any given point in time
so it is a perfectly inelastic line.
Supply is fixed by
the central bank

Value of
Money, 1/P
Price
Level, P
Quantity
of Money
1
¾
½
¼
1
1.33
2
4
MS1
$1000
Central Banks set MS
at some fixed value,
regardless of P.

Money Demand
(MD)
-is the relationship between the
quantity of money demanded and
Demand is set by how
much people want in
liquid form

1.) The Transactions motive:
To pay for stuff
2.) The Precautionary motive:
Just in case bad S#!% happens
3.) The Speculative motive:
To speculate on investments such as
bonds.
Liquidity theory
Money Demand
(MD)
much people want in
liquid form

Money Demand
(MD)
-is the relationship between the
quantity of money demanded and
much people want in
liquid form
Depends on P:
An increase in P reduces
the value of money,
so more money is required
to buy g&s.

Value of
Money, 1/P
Price
Level, P
Quantity
of Money
1
¾
½
¼
1
1.33
2
4
MD1
A fall in value of money (or
increase in P) increases the
quantity of money demanded:
Depends on P:
An increase in
P reduces the
value of money,
so more money
is required to
buy g&s.

Supply is fixed by
the central bank
The value of money is determined by the supply and demand for money
much people want in
liquid form
In the long run,
the overall price level adjusts to the level at which the
demand for money equals the supply of money.

MS1
$1000
Value of
Money, 1/P
Price
Level, P
Quantity
of Money
1
¾
½
¼
1
1.33
2
4
MD1
P adjusts to equate
quantity of money
demanded with money
supply.
EQ
price
level
EQ
value
of
money
A

MS1
$1000
Value of
Money, 1/P
Price
Level, P
Quantity
of Money
1
¾
½
¼
1
1.33
2
4
MD1
EQ
price
level
EQ
value
of
money
A
MS2
$2000
B
Then the value of
money falls,
and P rises.
Suppose the central
bank increases the
money supply.

How does this work? Short version:
 At the initial P, an increase in MS causes
excess supply of money.
 People get rid of their excess money by
spending it on g&s or by loaning it to others,
who spend it. Result: increased demand for
goods.
 But supply of goods does not increase,
so prices must rise.
Result from graph: Increasing MS causes P to rise.
Price
level
GDP
LRAS
Y
P1
P2

2.) Cost-Push
Negative supply
shock
- occurs when firms respond to
rising costs, by increasing prices
to protect their profit margins.
- Higher production costs
increase prices.
Easy Definition:
Textbook Definition:

Price
level
GDP
AD
SRAS
PE
LRAS
YN
SRAS1
Y1
P1
The bad kind of
inflation because
it involves lower
output.
2.) Cost-Push
Negative supply
shock

Cost-push inflation is really
the same as the term
Stagflation

2.) Cost-Push
Reasons:
a.) Input costs rise - Raw material costs rise.
b.) Labor costs rise - Pay more for workers means
increased input costs.
c.) Fall in the
exchange rate - Raw materials imported
costs rise.
d.) Expectations of
inflation
- If inflation is expected, raise
prices even higher.
***

A Perpetual 永恒 Process:
1.Workers demand raises.
2.Owners increase prices to pay for raises.
3. High prices cause workers to demand higher raises.
4. Owners increase prices to pay for higher raises.
5. High prices cause workers to demand higher raises.
6. Owners increase prices to pay for higher raises…
The Wage-Price Spiral
b.) Labor costs rise***

- occurs when aggregate demand is
growing at an unsustainable rate
leading to increased pressure on scarce
resources.
- Too many dollars chasing
too few goods.
Easy Definition:
Textbook Definition:3.) Demand-Pull

Price
level
GDP
AD
SRAS
PE
LRAS
YN Y1
P1
AD1
The good
kind of
inflation
because it
involves more
output.
3.) Demand-Pull

3.) Demand-Pull
Reasons:
a.) Growing economy - Demand rising faster then supply
can keep up.i.) *wealth effect
b.) Fall in the
exchange rate
- Demand internationally rising
faster then supply can keep up.
c.) Expectations of
inflation
prices even higher.

- a sustained increase in the cost of living or
the general price level leading to a fall in
the purchasing power of money.
Inflation
- is measured by the annual percentage
change in consumer prices.
Rate of
Inflation
- when the rate of inflation becomes
negative.
Deflation
- the value of money becomes worthless.Hyperinflation

- measures the typical consumer’s cost of
living with only the typical things that are
purchased.
- the main way to measure inflation.
Consumer Price
Index (CPI)

How the CPI Is Calculated:
- Government surveys consumers to
determine what’s in the typical consumer’s
“shopping basket.”
1.) Fix the “basket”
- Government then collects data on the
prices of all the goods in the basket.
2.) Find the prices
3.) Compute the
basket’s cost
-Use the prices to
compute the total cost of
the basket.

How the CPI Is Calculated:
- The CPI in any year equals:
4.) Choose a base year and compute the index
100 x
cost of basket in current year
cost of basket in base year
- The percentage change in the CPI from the preceding period:
5.) Compute the inflation rate
CPI this year – CPI last year
CPI last year
Inflation
rate
x 100%=

3.) Problems of CPI
*** The general problem is that CPI
tends to overstate the actual increase
in the cost of living.
- Introduction of New Goods
- Substitution Bias
- Unmeasured Quality Change
- Discount sales

Classical Dichotomy
Neutrality of Money
Velocity of Money (V of Money) - the rate at which money
changes hands.
v =
P x Y
M
Equation:

Long Run Aggregate
Supply (LRAS)
Price
level
GDP
LRAS
Y
P1
P2Therefore: With the quantity
equation (fisher equation) if V
is stable that means an increase
in M just means and increase
in P and not Y, so in the long
run we just have inflation only.
M x V = P x Y

Price
level
GDP
AD
SRAS
PE
LRAS
YN
SRAS1
Y1
P1
The bad kind
of inflation
because it
involves lower
output.
2.) Cost-Push
Negative supply
shock

2.) Cost-Push
Reasons:
a.) Input costs rise - Raw material costs rise.
b.) Labor costs rise - Pay more for workers means
increased input costs.
c.) Fall in the
exchange rate - Raw materials imported
costs rise.
d.) Expectations of
inflation
prices even higher.

The end of
part 2
Thank you 

Inflation SFLS types

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Inflation SFLS types