Name: ________________________________________________________________________________
CHAPTER 30 – Money Growth and Inflation
The Classical Theory of Inflation
 “Classical” - ideas developed by ____________________________________________________________________
 Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill
 Inflation affects the ______________________ of an economy’s _________________________________________
 Inflation ________________________ the value of money
 Each dollar buys a ___________________________________________ of goods and services
 Inflation Affects __________________________________________ in an Economy and
____________________________________
 Price level ___________________, people pay ________________________________________________
 Price level rises, lower ____________________________________, dollar buys _____________
(Ice-cream cone 1930s –______ cents, 2010 – ______dollars)
Money Supply, Money Demand and Monetary Equilibrium
 What determines the value of money?
 ____________________________________
 Determinants of money supply
 _________________ and ____________________________________
 How?
1. ___________________________________________________
2. ___________________________________________________
3. ___________________________________________________
 Determinants of money demand
 How much people want to ___________________________________________________ (in their wallets
to spend)
 Reliance on ___________________________________________, electronic currency substitutes
 Interest rate
– Higher interest rate, ________________ money demanded, lower, ____________ demanded
 Most important variable – average ________________________________ in the economy
– Higher prices, _______________ money it takes to consume, more __________________________
Supply and Demand of Money
 Why does quantity of money the Fed supplies balance the quantity of money people demand?
 Time Horizon – __________________________ or _____________________
 Monetary equilibrium - in the long run ______________________________________________________________
 __________________________ for money _________________ the _______________________ for money
 Price level is above equilibrium, people will ______________________________; prices will ____________
 Price level is below equilibrium, people will ______________________________; prices will ____________
Money Supply Graph
How the supply and demand for money determine the equilibrium price level
The horizontal axis shows the quantity of money. The left vertical axis shows the value of money, and the right vertical axis
shows the price level. The supply curve for money is vertical because the quantity of money supplied is fixed by the Fed.
The demand curve for money is downward sloping because people want to hold a larger quantity of money when each
dollar buys less. At the equilibrium, point A, the value of money (on the left axis) and the price level (on the right axis) have
adjusted to bring the quantity of money supplied and the quantity of money demanded into balance.
When the Fed increases the supply of money, the money supply curve shifts from MS1 to MS2. The value of money (on the
left axis) and the price level (on the right axis) adjust to bring supply and demand back into balance. The equilibrium moves
from point A to point B. Thus, when an increase in the money supply makes dollars more plentiful, the price level increases,
making each dollar less valuable.
The Effects of a Monetary Injection
 The Fed doubles the supply of money by through open-market operations
 New equilibrium
o Supply curve shifts __________________
o Value of money __________________
o Price level __________________
A brief look at the adjustment process
 Immediate effect of a monetary injection
 Creates an ___________________ supply of money
o QS_______QD of money
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
People will want to _________________________________ in two ways:
1. Increase in ______________________________________________________
2. _____________________ their money (_________, savings, cds etc.); allow others to
_________________________________________
Ultimately, price of goods and services _________________________ as a result of
___________________________________ of money
o Increase in __________________________________and quantity of money demanded creates a
_________________________________________
o Quantity Theory – more money, _________________________, higher price levels leads to
____________________________________
The Classical Dichotomy & Monetary Neutrality

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Classical dichotomy – division into two groups; division between the _____________________________ of the
economy and the ________________________________
 Theoretical separation of ____________________________ & _______________________variables
Nominal variables – variables measured in _________________________________
Real variables – variables measured in ____________________________________
 ___________________, Interest Rates, __________________, etc.
Monetary neutrality – changes in ______________________________ don’t affect ________________ variables,
only _________________________ variables
 Monetary neutrality is applicable in the ______________________ run, but not in the ______________ run
Velocity and the quantity equation
 Velocity of money (V)
 Average number of times a dollar is _______________________________________________ during a year
 _________________________ at which a dollar bill travels from ___________________________________
 How many times is a dollar bill used to pay for a newly produced good or service?
 Demand for money ________________________, the velocity of money increases
 Increase in demand for money is reflected in a _________________________________________________
 V = (P × Y) / M
 P = ________________________________ (GDP deflator)
 Y = ________________________________
 M = _______________________________
Velocity and the quantity equation
 Quantity Equation – shows that money supply has a ___________________, ______________________________
relationship with the price level.
 Quantity equation: M × V = P × Y
o _____________________________ (M)
o _____________________________ (V)
o ____________________________________________________________________ services (P × Y )
 Classical economists believed that velocity (V) of money was ____________________________, virtually
______________________________
 ______________________________ (Y) was unchanged by increases in _____________________________
 Y and V were _____________________________ by increases in money supply
 Increases in ___________________________________ (m) would lead to
___________________________________________ in price level (P)
 Quantity theory of money – direct link between ____________________________ and
____________________________
The Classical Theory of Inflation
 Five steps - essence of quantity theory of money
1. Velocity of money
 Relatively ________________________________
2. Changes in quantity of money (M)
 _________________________ changes in nominal value of output (P × Y)
3. Economy’s output of goods and services (Y)
 Primarily determined by _____________________
 Availability of _____________________________
 Because money is neutral
 Money does not affect __________________
4. Change in money supply (M)
 Induces proportional changes in the _______________________________ of output (P × Y)
 Reflected in changes in the __________________________ (P)
5. Central bank - increases the money supply rapidly
 High rate of _________________________
The Inflation Tax
 Why do countries experience inflation?
 Government spending
 Taxation – levying ________________, income, ________________, excise, ______________________, etc.
 Borrowing – selling of ____________________
 Printing of money
 Inflation tax – the revenue the government raises by _______________________
 No one receives a bill for this tax
 Increase _________________________, dollars ____________________________________
 Tax burden is on everyone that _________________________________
 U.S. – 3% inflation
 November 2008 estimated Zimbabwe's annual inflation rate at 89.7 sextillion (1021) percent. By December
2008, annual inflation was estimated at 6.5 quindecillion novemdecillion percent (6.5 x 10108%, the
equivalent of 6 quinquatrigintillion 500 quattuortrigintillion percent, or 65 followed by 107 zeros – one
googol 65 million percent).
Fisher Effect
 Real interest rate = ___________________________________ – _______________________________
 Bank posts nominal interest rate of __________% per year and inflation is ________%, real interest rate is
__________% per year
 Nominal interest rate = ___________________________________ + _______________________________
 Fisher effect – developed by Irving Fisher, ____________________________________ adjustment of
_______________________ interest rate to _________________________ rate
 Nominal interest rate adjusts to ____________________inflation
Unanticipated Inflation
 Problems arise when there is unanticipated inflation:
 Creditors _____________ and debtors ___________if the lender does not anticipate inflation correctly. For
those who borrow, this is similar to getting an ______________________________ loan.
 When the Fed increases the rate of money growth
o Higher ________________________________
o Higher ________________________________
Is Inflation a Problem?
The Costs of Inflation (real variables)
 Shoeleather costs
 Resources wasted when inflation encourages people to reduce their money holdings
 More _______________________ trips to the bank cause your shoes to wear out
 Menu costs
 Costs of __________________________
 Inflation – increases ______________________ that firms must bear
 Relative-price variability & misallocation of resources
 Inflation distorts __________________________, consumer and firms decisions become distorted
 Markets are not as efficient with __________________________________________
 Inflation - distorts relative prices
o Consumer decisions – distorted
o Markets - less able to allocate resources to their best use
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Confusion and inconvenience
 Money is the yardstick with which we measure ___________________________________________ (unit
of account)
 The Fed’s job is to ensure the ____________________________________________________
 When the Fed increases the money supply, creates __________________________________
 Erodes the real value of the _______________________________________________