# ECN 204 Lecture Notes - Money Supply, P Money

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22 Apr 2012
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ECN204Chapter 11 Notes
Classical Theory of Inflation
oInflation is an increase in the overall level of prices
Historical Aspects
Over the past 60 years, prices have risen an average of
Deflation, meaning decreasing average prices, occurred in
In the 1970s, prices rose by 7% per year
During the 1990s, prices rose at an average rate of 2% per
year
Quantity Theory of Money: long-run determinants of the price
level and the inflation rate
Inflation is an economy-wide phenomenon that concerns the
value of the economy’s medium of exchange
When the overall price level rises, the value of money falls
An inverse relationship between the price level and the
value of money
oHyperinflation is an extraordinary high rate of inflation.
The Value of Money
oP = Price Level (e.g., the CPI or GDP deflator)
P is the price of a basket of goods, measured in money
o1/P is the value of \$1, measured in goods
oExample: basket contains one candy bar
If P = \$2, value of \$1 is ½ candy bar
If P = \$3, value of \$1 is 1/3 candy bar
oInflation drives up prices and drives down the value of money
The Quantity Theory of Money
oDeveloped by 18th century philosopher David Hurne and the classical
economists
oAdvocated more recently by Nobel Prize Laureate Milton Friedman
oAsserts that the quantity of money determines the value of money
oWe study this theory using two approaches:
1. A supply-demand diagram
2. An equation
Money Supply (MS)
oIn real world, determined by Bank of Canada (BoC), the banking system,
consumers
oIn this model, we assume the BoC precisely controls money supply (MS)
and sets it at some fixed amount
Money Demand (MD)
oRefers to how much wealth people want to hold in liquid form
oDepends on P:
An increase in P reduces the value of money so more money is
required to buy goods and services
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oThus, quantity of money demanded is negatively related to the value of
money and positively related to P, other things equal.
These “other things” include real income, interest rates,
availability of ATMs, etc.
A Brief Look at the Adjustment Process
oResult from graph: Increasing MS causes P to rise
oHow does this work? Short version:
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 or by loaning it to others, who spend it
Result: increased demand for goods
But, supply of goods does not increase, so prices must rise
Real vs. Nominal Variables
oNominal Variables are measured in monetary units
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