Lecture 10 (Econtwo)

8/21/2019 Lecture 10 (Econtwo)

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INFLATION

Prepared by:

MARIA FRANCESCA TOMALIWAN

De La Salle University

10



O VERVIEW

Classical Dichotomy

Money Neutrality Fisher Effect

Inflation-induced ta distortion

!r"itrary redistri"utions of #ealth



$%E C&!''IC!& DIC%O$OM(

• Da)id %ume and his contem*oraries +1,th century

#rote that economic )aria"les should "e di)idedinto t#o .rou*s

– Nominal )aria"les/ )aria"les measured in monetary

units – Real )aria"les/ )aria"les measured in constant units

• Relati)e *rices are real )aria"les

• For eam*le real #a.e +adusted for inflation is a real

)aria"le

– $he di)ision of )aria"les into these t#o .rou*s is called

the classical dichotomy2

!



MONE( NE3$R!&I$(

• Da)id %ume and others su..ested that the

classical dichotomy is useful "ecause different

forces influence real and nominal )aria"les

• Real )aria"les do not chan.e #ith chan.es in the

money su**ly2

• Chan.es in the money su**ly affect nominal

)aria"les "ut not real )aria"les2

• $he irrele)ance of monetary chan.es for real

)aria"les is called monetary neutrality.

"



MONE( !ND 4RICE' D3RIN5 FO3R

%(4ERINF&!$ION'

Copyright © 2004 South-Western

(a) Austria

Index

(Jan. 1921 = 100)

Price level

100,000

10,000

1,000

100

1925

1924

1923

1922

1921

Money supply

(b) Hungary

Money supply

Price level

Index

(July 1921 = 100)

100,000

10,000

1,000

100

1925

1924

1923

1922

1921

#



$%E FI'%ER EFFEC$ • !ccordin. to money neutrality theory real interest rate

is not influenced "y monetary chan.es

• Recall/ – Real interest rate6nominal interest rate-inflation rate

• Re-arran.in. #e ha)e

• Nominal interest rate6real interest rate 7 inflation rate – Chan.e in the inflation rate chan.e in nominal interest rate

• $he Fisher effect refers to a one-to-one adustment of the

nominal interest rate to the e*ected inflation rate2 – #hen the rate of inflation rises the nominal interest rate

rises "y the same amount2

$



$%E CO'$' OF INF&!$ION

• 'hoe-leather costs/ the costs of reducin. money

holdin.s• Menu costs/ the costs of u*datin. *rices

• Relati)e-*rice )aria"ility/ the costs associated #ith

relati)e *rice distortion/• Confusion 8 incon)enience/ #ith risin. *rices it is

harder to com*are real re)enue *rices costs and

*rofits o)er time2• $a distortions

• !r"itrary redistri"utions of #ealth

%



INF&!$ION-IND3CED $!9 DI'$OR$ION

Inflation ea..erates the si:e of ca*ital .ains and

increases the ta "urden on this ty*e of income2

With *ro.ressi)e taation ca*ital .ains are taed

more hea)ily2

&



INF&!$ION-IND3CED $!9 DI'$OR$ION $he income ta system treats the nominal

interest earned on sa)in.s as income e)en

thou.h *art of the nominal interest rate merely

com*ensates for inflation2

$he after-ta real interest rate falls ma;in.

sa)in. less attracti)e2

'



%OW INF&!$ION R!I'E' $%E $!9 <3RDEN

ON '!VIN5 Economy 1

(price

stability)

Economy 2

(inflation) Real interest rate +r = > = >

Inflation rate 0> ,>

Nominal interest rate +i => 1?>

Reduced interest due to ?@> ta

6+02?@Ai

1> B>

!fter-ta nominal interest rate

After tax i6+02@Ai

B> >

!fter-ta real interest rate+after-tax i inflation rate

B> 1> ()



! R<I$R!R( REDI'$RI<3$ION'

OF WE!&$% 3ne*ected inflation redistri"utes #ealth amon.

the *o*ulation in a #ay that has nothin. to do

#ith either merit or need2

$hese redistri"utions occur "ecause many loans

in the economy are s*ecified in terms of the unit

of account money2

((

Lecture 10 (Econtwo)

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