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C H A P T E RC H A P T E R

13

Money and the Economy

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C H A P T E R 1 3 : M o n e y a n d t h e E c o n o m

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Money and the Price Level

• Do changes in the money supply affectsthe price level in the economy?

• Classical economists beloved so.

• Their position was based on the euationof e!change and the simple uantity theoryof money.

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Money and the Price Level "Continued#

• Equation of Exchange$ M% ≡ P&

• The money supply "M# multiplied by its%elocity "V# must be eual to the price level

"P# times 'eal (DP "Q#.

v e l o c i t y o f m o n e y

n o m i n a l G D P

m o n e y s u p p l y=

OR OR

Note: ≡ means “must be eual to!" this is an

identity#

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)nflation and the %elocity of Money

• The euation of e!change* or quantityequation, lin+s the money supply and velocityto nominal (DP$

• )f velocity is predictable* we can use theuantity euation and the supply of money topredict nominal (DP.

m o n e y s u p p l y v e l o c i t y n o m i n a l G D P x =

M ' P y x x=

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)nflation and the %elocity of Money

• The basic uantity euation can be used to derive a closely related formula for understanding inflation in the long run* called the growth version of thequantity equation$

• ,or e!ample$!ample$

Growth rateof the moneysupply

+Growthrate ofvelocity

=Growthrate ofprices

+Growth rateof real output

!" + !" =Growthrate ofprices

+ #"

$" = Growth rate of prices = inflation

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,rom the -uation of -!change to theimple &uantity Theory of Money

• The simple uantity theory of money assumes thatboth V and Q are constant.

• ,rom these assumptions* we have the simpleuantity theory of money$

• changes in M will bring aboutproportional changes in P.

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/ssumptions and Predictions of the imple&uantity Theory of Money

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The imple &uantity Theory in an /D0/,ramewor+

• M% is eual to total e!penditures.

• Total e!penditures is T- 1 C2)2(2"-30)M#

• ince M%1T-* M%1C2)2(2"-30)M#

• )n the simple uantity theory of money*velocity is assumed to be constant* so achange in money supply will changeaggregate demand and therefore lead to a

shift in the /D curve.

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The imple &uantity Theory in an /D0/,ramewor+ "Continued#

• )n the simple uantity theory of money* real(DP is fi!ed in short run. Thus* the /curve is vertical.

• /lso* in the simple uantity theory ofmoney* an increase in money supply willshift the /D curve rightward and increasesthe price level* and

• / decrease in the money supply will shift

the /D curve leftward and decreases theprice level.

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The imple &uantity Theory in an /D0/,ramewor+ "Continued#

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Dropping the /ssumptions that V and Q areConstant

• 'emember$ M ! % ≡ P ! &* then

P 1 M ! V

Q

• Money supply, velocity, and Real GDP determineMoney supply, velocity, and Real GDP determinethe Price Level.the Price Level.

• /n increase in M or V or a decrease in Q willcause prices to rise. This is inflation.

• / decrease in M or V or an increase in Q willcause prices to fall. This is deflation.

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Monetarism

• -conomists who emphasi4e the role thatthe supply of money plays in determiningnominal income and inflation are calledmonetarists. Today* most economists

agree with the monetarists that* in the longrun* inflation is caused by growth in themoney supply.

• Monetarists have not been content to rely

on the simple uantity theory of money.

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Monetarism$ 5ey %iews

6. %elocity changes in a predictable way.

7. /ggregate Demand depends on themoney supply and on %elocity.

8. The '/ curve is upward sloping.

9. The -conomy is elf0'egulating "Pricesand :ages are fle!ible#

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Monetarism in an /D0/ ,ramewor+

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The Monetarist %iew of the -conomy

• The economy is self0regulating

• Changes in velocity and the money supply canchange aggregate demand.

• Changes in velocity and the money supply willchange the price level and 'eal (DP in the shortrun* but only the price level in the long run.

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The Monetarist %iew of the -conomy

• Changes in velocity are not li+ely to offset changes in the moneysupply.

• Changes in the money supply will largely determine changes inaggregate demand* and therefore changes in 'eal (DP and the

price level.• /n increase in the money supply will raise aggregate demand

and increase both 'eal (DP and the price level in the short runand increase the price level "inflation# in the long run.

• / %ecrease in the money supply will lower aggregate demand

and decrease both 'eal (DP and price level "inflation# in theshort run and decrease price level in the long run.

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)nflation

• &nflation$ anyincrease in the price

level.• 'ne()hot &nflation$

one time increase inthe price level. Anincrease in the pricelevel that does notcontinue.

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;ne0hot )nflation$ Demand ide )nduced

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;ne0hot )nflation$ upply ide )nduced

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Continued )nflation ,rom ;ne0hot )nflation

Continued increases inaggregate demandcause continued

increases in inflation*or continued inflation.

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Changing ;ne hot )nflation )ntoContinued )nflation

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:hat Causes Continued )ncreases )n /ggregate Demand?

• The only factor that can change continually in sucha way as to bring about continued increases inaggregate demand is the money supplymoney supply.

• Money upply is the only factor that cancontinually increase without causing a reduction inone of the four components of total e!penditures$consumption "*#* investment "* governmentpurchases "G#* or net e!ports " M#.

M d ) t t ' t

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Money and )nterest 'ates:hat economic variables are affected by a change in

the money supply?

6. The supply of loans.

7. 'eal (DP

8. The price level

9. The e!pected inflationrate.

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Money and )nterest 'ates "Continued#

/ change in the money supply creates a change ininterest rates due to a change in$

• -iqui%ity Effect$ the supply of loanable funds.

• &ncome Effect$ 'eal (DP.• Price -evel Effect$ the price level.

• Expectations Effect$ the e!pected inflation rate.

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The )nterest 'ate and the Loanable ,undsMar+et

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:hat

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The =ominal and 'eal )nterest 'ates

• /ominal interest rate$ the interest rate actuallycharged "or paid# in the mar+et> the market interestrate.

• 1he 0eal &nterest 0ate$ the =ominal )nterest 'ateminus the -!pected )nflation 'ate.

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Coming p "Ch. 69#$ Monetary Policy

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/PP-=D)3

) fl ti d l t i th

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.. )nflation and nemployment in the6@ABs

• )n the early 6@ABs* high* real interest rateseventually caused the unemployment rate torise to over 6B by 6@A8.

• /s the actual unemployment e!ceeded thenatural rate of unemployment* the inflation ratefell* ust as was predicted by the e!pectationsPhillips curve. The severe recession had doneits ob in reducing the inflation rate.

Th D i f ) fl ti d

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The Dynamics of )nflation andnemployment* 6@AE06@@8

• /fter 6@AE* theunemployment rate beganto fall again* and as theactual unemployment fell

below the natural rate*inflation began to rise.

• )n 6@A@* the ,ed raisedinterest rates to combat

inflation. This reducedoutput and increasedunemployment to over Fby 6@@7.

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hifts in the =atural 'ate of nemployment

• The natural rate of unemploymentcan shift over time. The factors thatcause this include$

• Demographics* and the composition ofthe wor+force.

• )nstitutional changes* or changes inlaws and regulations that affect

unemployment benefits and restrictionsplaced on employers that ma+e itdifficult to fire wor+ers.

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hifts in the =atural 'ate of nemployment

• The natural rate of unemploymentcan shift over time. The factors thatcause this include$

• The state of the economy. Duringrecessions* wor+ers lose some of theirs+ills* which could lead to longer0termunemployment.

• Changes in the growth of laborproductivity. ne!pected productivitygrowth may be inconsistent withwor+ersG as+ing wages.

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early Monthly Growth 0ate

?olivia 7: ,:;,;!!" " 7"

5rgentina 77 #!;,;!! 7: 7#

/icaragua 7 7$:,:!! : 99

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Kudget Deficits and

ew macro 6

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