Chapter 8 Inflation This chapter examines the causes and consequences of inflation. Sections and relate inflation to money supply and demand. Although the presentation differs somewhat from that in Barro’s textbook, the results are similar. | Chapter 8 Inflation This chapter examines the causes and consequences of inflation. Sections and relate inflation to money supply and demand. Although the presentation differs somewhat from that in Barro s textbook the results are similar. In Section we extend Barro s analysis with a closer look at the real effects of inflation. Money Supply and Demand In most countries the general level of prices tends to increase over time. This phenomenon is known as inflation. In this section we will link inflation to changes in the quantity of money in an economy. The quantity of money is determined by money supply and demand. Before we can find out how supply and demand are determined we have to make precise what exactly is meant by money. Money is defined as the medium of exchange in an economy. Currency bank notes and coins is a medium of exchange but there are other commodities that fulfill this function as well. For example deposits on checking accounts can be used as a medium of exchange since a consumer can write a check in exchange for goods. There are other assets where it is not so clear whether they should be considered money or not. For example savings deposits can be used as a medium of exchange by making transfers or withdrawals but the main purpose of savings accounts is to serve as a store of value. In order to deal with these ambiguities economists work with a number of different definitions of money. These definitions are often referred to as monetary aggregates. One of the most important monetary aggregates is called M1 this measure consists of the currency in circulation plus checking deposits at banks. Broader aggregates like M2 and M3 also con 58 Inflation tain savings and time As a convention in this chapter we will identify money with M1 although most of the analysis would also work if we had broader aggregates in mind. Having defined money let us turn to money supply. Since we use Ml as our definition of money we have to find
