• Measured by CPI or GDP Deflator
• During last 70 years, prices have risen on avg. by about 4% per year
• Have been periods of deflation (late 1800s)
• Hyperinflation – extraordinarily high inflation

Classical Theory of Inflation
(Quantity Theory of Money)
• P (price level) is number of dollars needed to buy a basket of goods & services
• 1/P is value of money measured in terms of goods & services
• When price level rises, value of money falls

• Review of Money Supply & Money Demand
• In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply

• When Fed increases MS, price level increases while each dollar is less valuable
• Quantity Theory of Money: growth in quantity of money is primary cause of inflation

Classical Dichotomy &
Monetary Neutrality
• Nominal variables (measured in monetary units) vs. Real variables (measured in physical units)
• Separation of two sets of variables is called the classical dichotomy
• Dollar prices are nominal, relative prices are real

• Monetary Neutrality: changes in money supply do not affect real variables
• Pretty good description of how things work in the long run

• Velocity of Money – rate at which money circulates throughout the economy
• V = (P x Y)/M Divide nominal GDP by quantity of money
• Also can be written: M x V = P x Y and this is called the “quantity equation”
• Velocity is often assumed to be constant

Explanation of Equilibrium Price Level
& Inflation Rate
1. Velocity of $ is relatively stable
2. When quantity of $ changes (M), it causes proportionate changes in nominal value of output (P x Y)
3. Economy’s output (Y) is primarily determined by factor supplies & technology available, not by money

4. When money supply (M) changes it is reflected in changes in price level (P)
5. Therefore, when Fed changes money supply rapidly, the result is high inflation

1. Classical: Assumes Y & V are fixed, so expansionary policy can only lead to inflation
2. Keynesian: Don’t believe Y & V are fixed, don’t trust the effectiveness of monetary policy and instead emphasize fiscal policy
3. Monetarists: Demand for money is stable, expansionary monetary policy creates surplus of money & can increase real GDP but in long run it only leads to inflation
- Fixed money supply rule: equal to real growth rate

• When the government raises revenue by printing money – like a tax on anyone who holds money

• Remember:
Real Interest Rate = Nominal interest rate – inflation
• When the Fed increases the rate of money growth, the result is both a higher inflation rate and a higher nominal interest rate