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Chapter 12 Summary.pdf

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McMaster University
Bridget O' Shaughnessy

Summary of Lecture notes from Chapter 12 and Practice questions KEY POINTS: 1. The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money, it causes the price level to rise. Persistent growth in the quantity of money supplied leads to continuing inflation. 2. The principle of monetary neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. Most economists believe that monetary neutrality approximately describes the behavior of the economy in the long run. 3. A government can pay for some of its spending simply by printing money. When countries rely heavily on this “inflation tax,” the result is hyperinflation. 4. One application of the principle of monetary neutrality is the Fisher effect. According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, so that the real interest rate remains the same. 5. Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy, however, because inflation also raises nominal incomes. 6. Economists have identified six costs of inflation: shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to nonindexation of the tax code, confusion and inconvenience resulting from a changing unit of account, and arbitrary redistributions of wealth between debtors and creditors. Many of these costs are large during hyperinflation, but the size of these costs for moderate inflation is less clear. I. The Classical Theory of Inflation A. The Level of Prices and the Value of Money 1. When the price level rises, people have to pay more for the goods and services that they purchase. 1 2 ☞ Chapter 12/Money Inflation and Growth 2. A rise in the price level also means that the value of money is now lower because each dollar now buys a smaller quantity of goods and services. 3. If P is the price level, then the quantity of goods and services that can be purchased with $1 is equal to 1/ P. B. Money Supply, Money Demand and Monetary Equilibrium 1. The value of money is determined by the supply and demand for money. 2. For the most part, the supply of money is determined by the Bank of Canada. a. This implies that the quantity of money supplied is fixed (until the Bank of Canada decides to change it). b. Thus, the supply of money will be vertical (perfectly inelastic). 3. There are many determinants of the demand for money. a. One variable that is very important in determining the demand for money is the price level. b. The higher prices are, the more money that is needed to perform transactions. c. Thus, a higher price level (and a lower value of money) leads to a higher quantity of money demanded. Figure 12.1 Chapter 12/Money Inflation and Growth ☞ 3 4. In the long run, the overall price level adjusts to the level at which the demand for money and the supply of money are equal. a. If the price level is above the equilibrium level, people will want to hold more money than is available and prices will have to decline. b. If the price level is below equilibrium, people will want to hold less money than that available and the price level will rise. 5. We can show the supply and demand for money using a graph. a. The left▯hand vertical axis is the value of money, measured by 1/ P. b. The right▯hand vertical axis is the price level (P). Note that it is inverted ― a high value of money means a low price level and vice versa. c. At the equilibrium, the quantity of money demanded is equal to the quantity of money supplied. C. The Effects of a Monetary Injection 1. Assume that the economy is currently in equilibrium and the Bank of Canada suddenly increases the supply of money. 2. The supply of money shifts to the right. Figure 12.2 4 ☞ Chapter 12/Money Inflation and Growth 3. The equilibrium value of money falls and the price level rises. 4. When an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that makes each dollar less valuable. 5. Definition of quantity theory of money : a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate. D. A Brief Look at the Adjustment Process 1. The immediate effect of an increase in the money supply is to create an excess supply of money. 2. People try to get rid of this excess supply in a variety of ways. a. They may buy goods and services with the funds. b. They may use these excess funds to make loans to others. These loans are then likely used to buy goods and services. c. In either case, the increase in the money supply leads to an increase in the demand for goods and services. d. Because the supply of goods and services has not changed, the result of an increase in the demand for goods and services will be higher prices. E. The Classical Dichotomy and Monetary Neutrality 1. In the 18th century, David Hume and other economists wrote about the relationship between monetary changes and important macroeconomic variables such as production, employment, real wages, and real interest rates. 2. They suggested that economic variables should be divided into two groups: nominal variables and real variables. a. Definition of nominal variables : variables measured in monetary units. b. Definition of real variables: variables measured in physical units. 3. Definition of classical dichotomy : the theoretical separation of nominal and real variables. Chapter 12/Money Inflation and Growth ☞ 5 4. Prices in the economy are nominal, but relative prices are real. 5. Definition of monetary neutrality: the proposition that changes in the money supply do not affect real variables. F. Velocity and the Quantity Equation 1. Definition of velocity of money : the rate at which money changes hands. 2. To calculate velocity, we divide nominal GDP by the quantity of money. velocity = nominal GDP /money supply 3. If P is the price level (the GDP deflator), Y is real GDP, and M is the quantity of money: P × Y velocity = M 4. Rearranging, we get the quantity equation. M ×V = P ×Y 5. Definition of quantity equation : the equation M × V = P × Y, which relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services. a. The quantity equation shows that an increase in the quantity of money must be reflected in one of the other three variables. b. Specifically, the price level must rise, output must rise, or velocity must fall. c.
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