money growth and inflation_04
TRANSCRIPT
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Money Growth andMoney Growth and
InfationInfation
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Questions?Questions?
How does the money supply affect inflation and
nominal interest rates?
Does the money supply affect real variables likereal GDP or the real interest rate?
How is inflation like a tax?
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3
Introduction
The quantity theory of moneyto explain one of
the Ten Principles of conomics
Prices rise when the govt prints
too much money.
!ost economists believe the "uantity theory
is a #ood explanation of the lon# run behavior
of inflation$
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%
The Value o Money
P& the price level
'e.g.( the )P* or GDP deflator+
Pis the price of a basket of #oods( measured in
money$
,-Pis the value of ,( measured in #oods$
xample. basket contains one #lass of tea$
*f P& 2( value of , is ,-2 #lass of tea
*f P& 3( value of , is ,-3 #lass of tea
*nflation drives up prices and drives down the
value of money$
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/
The Quantity Theory oMoney
Developed by ,0thcentury philosopher
David Hume and the classical economists
1dvocated more recently by obel Prie 4aureate
!ilton 5riedman
1sserts that the "uantity of money determines the
value of money
6e study this theory usin# two approaches.
,$ 1 supply7demand dia#ram
2$ 1n e"uation
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8
Money Supply (MS)
Determined by 9:*( the bankin# system(
consumers
*n this model( we assume the 9:* precisely
controls !; and sets it at some fixed amount$
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$
Thus( "uantity of money demanded
is ne#atively related to the value of money
and positively related to P( other thin#s e"ual$'These other thin#s@ include real income(
interest rates( availability of 1T!s$+
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0
The Money SupplyDemand Dia!ram
Aalue of!oney( ,-P
Price
4evel( P
Buantityof !oney
, ,
C ,$33
2
E %
1s the price
level falls( value
of money rises$
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F
The Money SupplyDemand Dia!ram
Aalue of!oney( ,-P
Price
4evel( P
Buantityof !oney
,
C
E
,
,$33
2
%
MS,
,
The 9:* sets MS
at some fixed value(
re#ardless of P$
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,
The Money SupplyDemand Dia!ram
Aalue of!oney( ,-P
Price
4evel( P
Buantityof !oney
,
C
E
,
,$33
2
%MD,
1 fall in value of money
'or increase in P+increases the "uantity
of money demanded.
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,,
MS,
,
Aalue of
!oney( ,-P
Price
4evel( P
Buantityof !oney
,
C
E
,
,$33
2
%
The Money SupplyDemand Dia!ram
MD,
Pad>usts to e"uate
"uantity of moneydemanded with
money supply$
e"mpricelevel
e"mvalue
ofmoney
1
Th "# t M t
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,2
MS,
,
The "#ects o a MonetaryIn$ection
Aalue of
!oney( ,-P
Price
4evel( P
Buantityof !oney
,
C
E
,
,$33
2
%MD,
e"m
pricelevel
e"m
valueofmoney
1
MS2
2
:
Then Prises
and the value
of money falls$
;uppose the 9:*
increases the
money supply$
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,3
% &rie 'oo at the %d$ustmentrocess
How does this work? ;hort version.
1t the initial P( an increase in !; causes
excess supply of money$
People #et rid of their excess money by spendin#it on =i>or by loanin# it to others( who spend it$
9esult. increased demand for #oods$
:ut supply of #oods does not increase(
so prices must rise$
9esult from #raph. *ncreasin# !; causes P to rise$
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,%
*eal +s, -ominal Varia.les
Nominal variablesare measured in monetary
units$
Examples: nominal GDP(
nominal interest rate 'rate of return measured in
9s$+nominal wa#e '9s$ per hour worked+
Real variablesare measured in physical units$
Examples: real GDP(real interest rate 'measured in output+
real wa#e 'measured in output+
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,/
*eal +s, -ominal Varia.les
Prices are normally measured in terms of money$
Price of a compact disc. ,/-cd
Price of a pepperoni pia. ,-pia
1 relative price is the price of one #ood relative to
'divided by+ another.
9elative price of )Ds in terms of pia.
price of cd
price of pia
,/-cd
,-pia&
9elative prices are measured in physical units(
so they are real variables$
& ,$/ pias per cd
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,8
*eal +s, -ominal /a!e
1n important relative price is the real wa#e.
W& nominal wa#e & price of labor( e.g.,,/-hour
P& price level & price of =i>( e.g.,/-unit of output
9eal wa#e is the price of labor relative to the priceof output.
W
P
& 3 units output per hour,/-hour
/-unit of output
&
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,ust the unit of
account$ )han#es in the unit of account dontchan#e real "uantities( in the same way that
measurin# hei#ht in inches rather than feet
doesnt chan#e how tall you are$
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2,
The Quantity "1uation
otation.
Px Y & nominal GDP
& 'price level+ x 'real GDP+
M & money supply
V & the velocity of money 'the rate at which
money chan#es hands+
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The Quantity "1uation
Mx V & Px Y
This is the quantity equation
Assume that output, Y, is fixed by inputs,
resources and technology Assume that the money supply, M, is fixed as
well
hen the price level, !, is determined by ",the velocity of money
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-ominal GD2 M32 and Velocity (1960=100)1960-2007
ominal GDP
!2
Aelocity
Aelocity is fairly
stable over time$
Aelocity is fairly
stable over time$
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2%
The Quantity Theory
#$ V is stable$
%$ ;o( a chan#e in Mcauses nominal GDP 'Px Y+
to chan#e by the same percenta#e$
&$ 1 chan#e in Mdoes not affect Y. money is neutral(
Y is determined by technolo#y K resources
'$ ;o( P chan#es by same percenta#e asPx Y and M$
($ 9apid money supply #rowth causes rapid inflation$
;tart with "uantity e"uation. Mx V & Px Y
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"4ercise"4ercise
25
Lne #ood. )lock$ The economy has enou#h labor(capital( and land to produce Y& 0 bushels of corn$
Vis constant$ *n 20( !; & 2( P& /-)lock$
5or 2F( the 9:* increases !; by /M( to 2,$
a$ )ompute the 2F values of nominal GDP and P$
)ompute the inflation rate for 2072F$
b$ ;uppose tech$ pro#ress causes Y to increase to02% in 2F$ )ompute 2072F inflation rate$
2/
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Given. Y& 0( Vis constant(!; & 2 and P& / in 20$
5or 2F( the 9:* increases !; by /M( to 2,$
a$ )ompute the 2F values of nominal GDP and P$)ompute the inflation rate for 2072F$
ominal GDP & Px Y & Mx V 'Buantity "n+
P & P x Y
Y
& %2
0& /$2/
& 2, x 2 & %2
*nflation rate &/$2/ I /$
/$& /M 'same as !;N+
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