Money Growth and Inflation_04

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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?

22


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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


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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,


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

%


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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22

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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Money Growth and Inflation_04