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8/21/2019 Lecture 10 (Econtwo)
http://slidepdf.com/reader/full/lecture-10-econtwo 1/11
INFLATION
Prepared by:
MARIA FRANCESCA TOMALIWAN
De La Salle University
10
8/21/2019 Lecture 10 (Econtwo)
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O VERVIEW
Classical Dichotomy
Money Neutrality Fisher Effect
Inflation-induced ta distortion
!r"itrary redistri"utions of #ealth
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$%E C&!''IC!& DIC%O$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
– $he di)ision of )aria"les into these t#o .rou*s is called
the classical dichotomy2
!
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MONE( NE3$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
• $he irrele)ance of monetary chan.es for real
)aria"les is called monetary neutrality.
"
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MONE( !ND 4RICE' D3RIN5 FO3R
%(4ERINF&!$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
#
8/21/2019 Lecture 10 (Econtwo)
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$%E FI'%ER EFFEC$ • !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
$
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$%E CO'$' 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• $a distortions
• !r"itrary redistri"utions of #ealth
%
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INF&!$ION-IND3CED $!9 DI'$OR$ION
Inflation ea..erates the si:e of ca*ital .ains and
increases the ta "urden on this ty*e of income2
With *ro.ressi)e taation ca*ital .ains are taed
more hea)ily2
&
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INF&!$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
$he after-ta real interest rate falls ma;in.
sa)in. less attracti)e2
'
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%OW INF&!$ION R!I'E' $%E $!9 <3RDEN
ON '!VIN5 Economy 1
(price
stability)
Economy 2
(inflation) Real interest rate +r = > = >
Inflation rate 0> ,>
Nominal interest rate +i => 1?>
Reduced interest due to ?@> ta
6+02?@Ai
1> B>
!fter-ta nominal interest rate
After tax i6+02@Ai
B> >
!fter-ta real interest rate+after-tax i inflation rate
B> 1> ()
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! R<I$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
((