Lecture 3

• The Classical Dichotomy states that production is decided by real forces and is exogenous
• The velocity of money is exogenously given and constant over time according to the Classical Dichotomy
• Money supply is determined by the central bank and monetary policy is exogenous in the Classical Dichotomy
• When all prices in the economy double, relative prices remain unchanged
• When the relative prices of goods are unchanged, no real values are affected
• The Neutrality of money states that changes in the money supply have no real effects on the economy, affecting only prices and not variables like unemployment
• The Neutrality of money holds in the long run, but not the short run, because price changes slowly
• When commodity money was used, the money supply was not linked to economic growth
• When commodity money was used, money supply changed due to the value and quality of gold produced
• The use of commodity money meant that inflation was small, and deflation was just as likely as inflation
• Common periods of deflation when using commodity money were risky, as it reduced demand
• Consumer price index is a price index for a bundle of goods
• Consumer price inflation shows inflation of what the average consumer would buy
• Measuring Consumer Price Inflation is complicated due to discounts and promotions making it difficult to measure the consumer price index
• Changes to the basket of goods are needed to keep the measured Consumer Price Inflation relevant
• changing the basket of goods reduces the ability to compare inflation over time
• The basket is changed once per year
• Changing the basket of goods used to measure CPI only once a year was a big issue at the start of the Covid pandemic
• in 2020 consumption changed drastically without the CPI basket reflecting this
• Fiscal drag is a consequence of inflation
• Taxes are based on nominal incomes, and brackets are fixed and do not move with inflation
• Economic decisions are based on real variables
• Fiscal drag occurs because when people's income increases due to higher inflation, they have to pay more tax, despite their real income not changing
• fiscal drag results in their real net income decreasing, despite no change in real gross income
• Fiscal policy is set by the Treasury
• The Treasury sets fiscal policy following instructions from the House of Commons
• Fisher equation: Nominal interest rate = Real interest rate + Inflation
• Nominal interest rate is high when inflation is high
• Real interest rate can deviate from the natural rate
• Prices are sticky, meaning a change in real interest rate can cause a change in nominal interest rate
• hyperinflation is an episode of extremely high inflation- over 500% per year
• Inflation is the percentage change in the overall price level
• UK inflation peaked in the 1970s / 1980s to almost 25% due to oil price shocks and the Thatcher government
• Inflation becomes entrenched and harder to fight the longer it persists
• People with pensions or incomes not linked to inflation, or only linked to inflation with a delay, are hurt during inflation
• In general, inflation hurts people and organizations where income is not immediately linked to inflation
• Banks issuing loans at fixed rates but paying interest rates that move with the market can suffer losses during inflation
• Large surprise inflations lead to larger distributions in wealth
• Surprise inflation allows people with debts to pay back loans with new, lower value dollars, making creditors the losers
• Inflation distorts relative prices, as some prices adjust faster than others and change differently to inflation