Question

1. Classical Theory of inflation; Classical Dichotomy: how nominal and real variables are affected by changes in money supply in the long run? In the short-run? Define and bring examples of nominal and real variables.

2. The costs of inflation: Shoeleather costs; Menu costs; Arbitrary redistributions of wealth as a result of unexpected inflation between debtors and creditors: When do debtors gain (when inflation is smaller than expected)? When do creditors gain (when inflation is higher than expected)?

Answer 1

Answer 1:

According to Classical Theory of Inflation, chabges in the money supply impact both real and nominal variables in the short run but in the long run, it only impacts nominal variables and has no impact on real variables in the economy. Nominal variables are the variables which are not adjusted for price level. For example, Nominal GDP, Inflation rate, Nominal Interest Rate etc. On the other hand, variables which are adjusted for inflation rate are known as Real Variables and examples include Real GDP, Real Interest rate etc. Changes in money supply impacts real variables in the short run but has no impact on real variables in the long run.

Answer 2:

Debtors or the borrowers of money gain when inflation is higher than expected because they received money with high purchasing value and have to return money with low purchasing power. On the other hand, creditors gain when inflation is smaller than expected because when inflation is smaller then they receive money from debtors which has high purchasing power as compared to the purchasing power of money when it was lent.