Opening
Assume that there is an increase in the demand
for money at every interest rate. Graph the
effect this will have on equilibrium interest rate
for a given money supply.
Now assume that the Fed is following a policy of
targeting the Federal Funds Rate. What will the
Fed do in the situation described to keep the
rate unchanged. Illustrate on the graph.
Types of Inflation, Deflation and
Disinflation
Module 33
Classical Model of Money and Prices
The classical view of changes in money supply is
that they lead directly to changes in the price
level
Nominal v. Real Money Supply:
Nominal = M
Real = M/P
Thus, the real money supply remains unchanged
Figure 33.1 The Classical Model of the Price Level
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
Hyperinflation
Hyperinflation is most often caused by excessive
money creation to cover government debt:
1. Too much debt means investors lose confidence in
currency (dump it)
2. Central bank needs to create money to buy
government bonds
3. Inflation increases rapidly (vicious cycle)
Seignorage: The ability of governments to pay for
debt by creating money
Inflation Tax
Governments can pay debts by raising taxes
However, if they pay debts by printing money,
causing hyperinflation, they are in a sense
“taxing” their citizens by the loss of purchasing
power
This is the “inflation tax”
Hyperinflation v. Gradual Inflation
At high rates of inflation, classical model holds
But at gradual rates of inflation, prices are
“sticky” and short-run changes matter
Why? - Expectations
Gradual Inflation
Cost-push inflation
Price level increases due to cost of major input
Stagflation of the 1970s
Demand-pull inflation
Price level increases as a result of competition for
goods, increasing wages
Too many dollars chasing too few goods
Output Gap and Unemployment
In earlier unit we examined the relationship
between unemployment and output
In long-run macroeconomic equilibrium, the
unemployment rate is equal to the natural rate
– Recessionary gap: Unemployment is greater than
the natural rate
– Inflationary gap: Unemployment is less than the
natural rate
Figure 33.3 Cyclical Unemployment and the Output Gap
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers