Lecture # Chapter 11
Money Growth and Inflation
Classical Theory of Inflation
• Price of a good to some extent reflect value
• Money – value of falls as the price level rises
• Households demand money because we want to buy stuff
• Demand for money (households) – as prices rise we need more money to buy the same
amount of stuff
• The demand for money curve has a negative slope
When we are drawing a demand curve for money, we use 1/P as the variable on the vertical
axis, which represents the value of money.
If P goes down, 1/P must be going up, and vice versa.
M(d) – Shift out if Y rises or if households decide to increase their money holdings for some
M(s) vertical – position determined by the central bank.
Quantity Theory of Money
• This theory suggests that the quantity of money determines the price level.
• The growth rate of money determines the inflation rate.
• The separation of real and nominal variables.
• The real variable (production rate) is determined by different forces.
• Changes in the Money Supplied (Ms) affect nominal variable, but not real variables. Velocity
• The rate which money changes hands
Example: produce 2000 cups of hot chocolate/ week
$2 per cup
$500 of currency in the economy
How many times must each dollar circulate through the economy for all hot chocolate to be
M(money) x V(Velocity) = P(price) xY(real GDP)
• Px Y equals nominal GDP
The growth rate of the product of two variables is (approximately) equal to the sum of the
growth rates of the individual variables
Q1 from pg.264
Suppose that this year’s money supply is $50 billion, norminal GDPis $1 trillion, and real
GDPis $500 billion
a) What is price level?2 What is the velocity of money?20
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 GDPand the price level next year if the
Bank of Canada keeps the money supply constant?
Normal GDPconstant, Pgo down 5%
Thy is inflation bad for the econo