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III
Aman
12 April 2013
Pakistan has experienced periods of very high inflation and even periods of deflation.
In the 1970s, prices rose by more than 12 percent per year, on average. During the 1980s and 1990s, prices rose at an average rate of 7-9 percent per year.
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0 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 -5
When the overall price level rises, the value of money falls.
The money supply can be used as a policy variable under a system with required reserve ratio.
By controlling the required reserve ratio the SBP directly control the quantity of money supplied. Other countries such as the US and the UK continue to use this system.
Money supply, money demand and monetary equilibrium People hold money because it is the medium of exchange and hence money demand depends on the exchange norm and facilities. However, by holding money they forgo interest earnings and hence vary their demand inversely with changes in the interest rate. Also, the amount of money people choose to hold depends on their income, the prices of goods and services.
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the technology of exchange (norms and facilities) such as the frequency of use of credit cards, bank charges, etc.
Short run prices do not change, nominal interest rates change. Long run prices are fully flexible, nominal interest rates are fixed by the Fishers rule for offsetting the effects of inflation.
Figure 7 Nominal interest rate 25% 20% 15% 10% 5% 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 Inflation
i p r, p e p .
In the LONG RUN, interest rates are determined as follows: (1) real interest rate (r) is determined in the financial market such that S = I and (2) nominal interest rate (i) is determined by the Fishers effect such that given expected inflation (pe)
i r p
In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.
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We assume that, everything else (such as national income, Y) remaining constant, if price level increases, the amount of money we demand increases too. Lets define the purchasing power of a $1 = 1/P to be the price of money. By that definition, the demand for money would be a downward sloping function of its price, 1/P.
How the supply and demand for money determine the equilibrium price level
MS1
/4
1.33
C
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New MD (High)
(Low) 0 M1 Old MD
Quantity of Money
MS1
MS2
/4
1.33
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D
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B
M2
New MD (High)
(Low) 0 M1 Old MD
Quantity of Money
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Individuals now hold more money than they desire. They will increase consumption to compensate.
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Inflation results when the money supply grows faster than real GDP.
Hyperinflation
Case study: Money and prices during four hyperinflations
Hyperinflation is inflation that exceeds 50 percent per month. Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.
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(a) Austria Index (Jan. 1921 = 100) 100,000 10,000 1,000 100 Price level Money supply Index (July 1921 = 100) 100,000
(b) Hungary
1921
1922
1923
1924
1925
1921
1922
1923
1924
1925
(c) Germany Index (Jan. 1921 = 100) 100,000,000,000,000 1,000,000,000,000 10,000,000,000 100,000,000 1,000,000 10,000 100 1 Price level Money supply Index (Jan. 1921 = 100) 10,000,000 1,000,000 100,000 10,000 1,000 1921 1922 1923 1924 1925 100 1921 1922
(d) Poland
1923
1924
1925
Hyper Inflation
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Inflation tax
When the government raises revenue by printing money, it is said to levy an inflation tax. An inflation tax is like a tax on everyone who holds money. The inflation ends when the government institutes fiscal reforms such as cuts in government spending.
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Summary
The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation.
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Summary
The principle of money neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. A government can pay for its spending simply by printing more money. This can result in an inflation tax and hyperinflation.
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Summary
According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount and the real interest rate stays the same. Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy because inflation also raises nominal incomes.
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Summary
Economists have identified six costs of inflation: shoe leather costs menu costs increased variability of relative prices unintended tax liability changes confusion and inconvenience arbitrary redistributions of wealth.
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