Money Supply, Inflation, and Unemployment

Money Supply, Money Supply, Inflation, and Inflation, and

UnemploymentUnemployment

The Equation of The Equation of ExchangeExchange

MV = PYMV = PY

So…So…

%%ΔΔM + M + %%ΔΔV ≅ V ≅ %%ΔΔP + P + %%ΔΔYY

M = Money SupplyM = Money Supply V = Money VelocityV = Money Velocity P = Price LevelP = Price Level Y = real GDPY = real GDP

Inflation Rate in Long Inflation Rate in Long RunRun

Since Velocity tends to remain culturally constant, Since Velocity tends to remain culturally constant,

%%ΔΔM + 0 ≅ M + 0 ≅ %%ΔΔP + P + %%ΔΔY Y

OrOr

%%ΔΔM ≅ M ≅ %%ΔΔP + P + %%ΔΔY Y

Or, to understand inflation…Or, to understand inflation…

%%ΔΔP ≅ P ≅ %%ΔΔM — M — %%ΔΔYY


LRAS and InflationLRAS and Inflation

This explains why the European Central Bank This explains why the European Central Bank focuses their analysis on money supplyfocuses their analysis on money supply

If rGDP grows by 2 or 3% per year, then %If rGDP grows by 2 or 3% per year, then %ΔΔM M reliably determines inflationreliably determines inflation

%%ΔΔP ≅ P ≅ %%ΔΔM — M — %%ΔΔYY%%ΔΔP ≅ P ≅ %%ΔΔM — 3M — 3%%


Unemployment: Unemployment: Reservation WageReservation Wage

Employees want the Employees want the highest wage highest wage possiblepossible

Employers generally Employers generally want to pay the want to pay the least required (but least required (but not always)not always)

As time unemployed As time unemployed lengthens, lengthens, employees are employees are willing to take lower willing to take lower wages, but are wages, but are likely to find higher likely to find higher wage possibilitieswage possibilities

US Unemployment RateUS Unemployment Rate


Government Government policy can policy can affect wages affect wages and and unemployment unemployment durationduration

Welfare and Welfare and unemployment unemployment relief payments relief payments extend durationextend duration

Effect on wages Effect on wages and duration?and duration?

RW1RW2

Wage

Duration of Search

BOR


Faster and more Faster and more complete spread complete spread of information can of information can lead to higher BoRlead to higher BoR

Monster.com and Monster.com and other Internet other Internet sites increase job sites increase job vacancy vacancy awarenessawareness


RW2

Wage

Duration of Search

BOR1BOR2


What is the What is the effect of the effect of the comb-ination of comb-ination of unemployment unemployment payment policy payment policy and increased and increased spread of spread of information?information?


RW2

Wage

Duration of Search

BOR2 BOR1

RW1

Scenario 1Scenario 1 The government, The government,

faced with rising faced with rising budget deficits, budget deficits, decides to limit decides to limit unemployment unemployment payments to only 4 payments to only 4 weeks.weeks.

What is the effect What is the effect on output, rGDP, on output, rGDP, and Price Level? and Price Level? (Use which graph?)(Use which graph?)

What is the likely What is the likely effect on wages effect on wages and the typical and the typical duration of search duration of search for a worker?for a worker?

AD2AD1

PL

rGDP

SRAS

RW2RW1

Wage

Duration of Search

BOR

Scenario 2Scenario 2 ECB statistics show ECB statistics show

that the money that the money supply is increasing supply is increasing by 8%. rGDP is by 8%. rGDP is increasing by 3%.increasing by 3%.

What is the expected What is the expected inflation rate?inflation rate?

What monetary What monetary policy should the policy should the ECB take to redress ECB take to redress the situation?the situation?

What effect will this What effect will this policy have on the policy have on the value of the US dollar value of the US dollar relative to the euro?relative to the euro?

D2D1

Exchange R

ate of Dollar in E

uros

Q of $

S1 S1

MD

Real Interest R

ate

Q of $

MS1MS2

r1

r2

Documents

Money Supply, Inflation, and Unemployment