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ECON1000 CH. 11.docx

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Carleton University
ECON 1000
Nick Rowe

Introduction (A Recap) • Discussing how the money supply affects prices, inflation, value of money • These variables are determined in the money market A Brief Look at the Adjustment Process Case: Bank of Canada increases MS causing price to rise How does the adjustment work? • At the initial P, an increase in MS causes excess supply of money • People get rid of their excess money by spending it on goods and services • Result: increased demand in goods. • But supply of goods does not increase so prices must rise. What does this say? If economy is at full employment, natural rate of employment •Then amount of goods and services economy can produce is fixed •Hence, increase in money supply causes the price level to rise...inflation •More dollars chasing a fixed amount of goods and services. This causes prices to rise. The Classical Theory of Inflation •Classical theory of inflation is built around the quantity theory of money •Quantiy theory of money asserts: o Quantity of money available determines the price level o The growth rate of money determines the inflation rate o Inflation affects the value of money •We are going to look at some elements of this theory in greater detail o Classical Dichotomy o Monetary Neutrality o Quantity Equation o Costs of Inflation The Classical Dichotomy •Classical dichotomy: the theoretical seperation of nominal and real variables •David Hume (18th century philosopher) and the classical economists suggested that monetary developments affect nominal variables but not real variables •If central bank doubles the money supply, all nominal variables--including prices--will double •All real variables--including relative prices--will remain unchanged Real vs. Nominal Variables •Nominal variables are measured in monetary units o Examples: nominal GDP, nominal wage ($ per hour work) •Real variables are measured in physical units o Examples: real GDP, real wage (measured in output) •Prices are normally measured in terms of money o Prices of a compact disc: $15/cd o Price of a pepperoni pizza: $10/pizza •A relative price is the price of one good relative to (divided by) another: o Relative price of cds in terms of pizza: (price of cd/price of pizza) = ($15/$10) = 1.5 pizzas per cd The Neutrality of Money •Money Neutrality: the proposition that changes in the money supply affect nominal variables but do not affect real variables •Doubling money supply causes all nominal prices to double; but what happens to relative prices? •Initially relative price of cd in terms of pizza is 1.5 pizzas per cd •After nominal prices double o (price of cd/price of pizza) = (30/20) = 1.5 pizzas per cd o Therefore, the relative price is unchanged Real vs. Nominal Wage •An important relative price is the real wage: o W: nominal wage = price of labour, e.g. $15/hour o P: price level = price of goods and services, e.g. $5/unit of output •Real wage is the price of lavour relative to the price of output: o (W/P) = ($15 per hour/$5 per unit) = 3 units output per hour •Lets double the nominal wage and nominal price: o (W/P) = (30 per hour/$10 per unit of labour) = 3 units output her hour o Once again, relative wage is unchanged The Neutrality of Money •Most economists believe the classiccal dichotomy (the theoretical seperation of nominal and real values) and neutrality of money (the proposition that changes in the money supply only affect nominal values but do not affect real variables) The Classical Theory of Inflation •The neutrality of money applies in the long run at the natural rate of unemployment •In later chapters (14, 15, 16) we will see that monetary changes can have important short-run effects on real variables Classical Dichotomy •According to the classical dichotomy, there is a theoretical seperation between nominal and real variables •Nominal variables are determined primarily by developments in the monetary system, such as chanes in money demand and supply •Real variables are largely independent of the monetary system (i.e. monetary neutrality) •What inf
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