# ECON 1BB3 Lecture Notes - Classical Dichotomy, Money Supply, Hot Chocolate

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Published on 12 Apr 2013

Department

Economics

Course

ECON 1BB3

Professor

Richard Damra Tuesday, February 26, 2013

Econ 1BB3 – Chapter 11

Why is the inflation rate 2.5% in Canada but 19% in Venezuela?

Classical Theory of Inflation

Price of a good – reflects value

Money – Value falls as the price level rises

Demand for money (households) – as prices rise we need more money to buy the same goods.

The demand for money curve has a negative slope

When P goes up, value of money goes down

Vertical axis = 1/P (Value of money)

If 1/P goes down P goes up and vice versa

Md (Money Demand) – shift out if Y rises or if households decide to increase their money

holdings for some other reason.

Y stands for several things, depends on context, in this context, Income. Can also be GDP

(Output).

Ms (Money Supply) vertical – position determined by the central bank

Increasing the money supply shifting the line to the right, decreasing shifting to the left.

Richard Damra Tuesday, February 26, 2013

Quantity theory of Money

Quantity theory of money:

o The quantity of money determines the price level

o The growth rate of money determines the inflation rate

o The faster the money is printed the faster the growth of inflation rate (Answer to

lecture’s question

Classical dichotomy: the separation of real and nominal variables. Real variable are measured in

physical quantities or their relatives’ i.e sack of potatoes in terms of rice or measured in some

form of constant dollars. Nominal is measured in terms of current dollars. Real variables are

determined by other real variables

Monetary neutrality: Changes in Ms affect nominal variables, but not real variables.

Velocity

Velocity: rate at which money changes hands

Example: produce 2000 cups of hot chocolate / week

o $2 per cup

o $500 of currency in the economy

o How many times must each dollar circulate through the economy for all the hot

chocolate to be purchased?

o 8 times

Quantity Equation

The growth rate of the product of two variables is (approximately) equal to the sum of the

growth rates of the individual variables.

Richard Damra Tuesday, February 26, 2013

Question 1 from Page 264

Suppose that this year’s money supply is $50 billion, nominal GDP is $1 trillion, and real GDP is

$500 billion.

o A) What is price level? What is velocity of money?

Py = $1000 Billion M=$50 Billion y=$500billion

P= Py/y = 1000/500 = 2 Price level

MxV=PxY

V=PxY/M=1000/50=20 Velocity

o B) Suppose that velocity is constant and the economy’s output of goods and services

rises by 5 percent each year. What will happen to nominal GDP and the price level next

year if the Bank of Canada keeps the money supply constant.

Nominal GDP is constant because Velocity is constant which makes M constant

and makes the right side of the equation MxV = PxY constant

o C) What money supply should the bank of Canada set next year if it wants to keep the

price level stable

Increase M by 5% therefore M=$52.5 billion

o D) What money supply should the bank of Canada set next year if it wants inflation of

10%?

P increase by 10% and Y increase by 5%

Money supply should increase by 15% therefore M = $57.5B

## Document Summary

Price of a good reflects value. Money value falls as the price level rises. Demand for money (households) as prices rise we need more money to buy the same goods. The demand for money curve has a negative slope. When p goes up, value of money goes down. Vertical axis = 1/p (value of money) Md (money demand) shift out if y rises or if households decide to increase their money. If 1/p goes down p goes up and vice versa holdings for some other reason. Y stands for several things, depends on context, in this context, income. Ms (money supply) vertical position determined by the central bank. Increasing the money supply shifting the line to the right, decreasing shifting to the left. Classical dichotomy: the separation of real and nominal variables. Real variable are measured in physical quantities or their relatives" i. e sack of potatoes in terms of rice or measured in some form of constant dollars.