ECN 204 Lecture Notes - Nominal Interest Rate, Gdp Deflator, Classical Dichotomy

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25 Apr 2012
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Chapter 11: Money Growth and Inflation
Inflation: is an increase in the overall level of prices
Hyperinflation: is an extraordinarily high rate of inflation
Historical Aspect of Inflation: Over the past 60 years, prices have risen on average about 4 percent per
year. Deflation (decreasing average prices) occurred in Canada in the twentieth Century. In the 1970s,
prices rose by 7 percent per year. During the 1990s, prices rose at an average rate of 2 percent per year.
The Classical Theory of Inflation
The Level of prices and the Value of money
Quantity Theory of Money: is used to explain the long term determinants of the price level and 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
-Inflation is more about the value of money than about the value of goods
Economy’s Overall Price can be measured in 2 ways:
1) View the price level as the price of a basket of goods and services. When the price level rises,
people have to pay more for the goods and services they buy
2) View the price level as a measure of the value of money. A rise in the price level means a lower
value of money because each dollar in your wallet now buys a smaller quantity of goods and
services.
Value of Money
P= the price level (CPI or GDP deflator), P is the price of a basket of goods, measured in money
1/P= the value of $1, measured in goods
Example: Basket contains one candy bar.
If P= $2, value of $1 is 1/2 candy bar
If P=$3, value of $1 is 1/3 of candy bar
-Inflation drives up prices and drives down the value of money.
Money Supply, Money Demand, and Monetary Equilibrium
Quantity Theory of Money: asserts that the quantity of money determines the value of money. The
theory has two approaches: a supply-demand diagram and an equation.
Money Supply: In the real world, is determined by the Bank of Canada, the banking system, and
consumers. In class, we assumed the Bank of Canada precisely controls money supply and sets it at
some fixed amount
Money Demand: how much wealth people want to hold in liquid form “liquidity preference”. One
important variable that affects money demand is the average level of price in the economy. People hold
money because it’s a medium of exchange= high price level (lower value of money) increases the
quantity of money demanded.
-In the long run, the overall level of prices adjust to the level at which the demand for money equals the
supply
Money Supply Demand Graph: Horizontal Axis
shows the quantity of money. Left Vertical Axis
shows the Value of Money. Right Vertical Axis
shows the Price Level. The supply curve for
money is vertical because the quantity of money
supplied is fixed by BOC. The demand curve for
money is downward sloping because people
want to hold a larger quantity of money when
each dollar buys less.
The Effects of Monetary Injection
-Monetary injections shifts the supply curve to
the right from MS1 to MS2 and the
equilibrium moves from point A to point B.
The value of money decreases from ½ to ¼
and the equilibrium price level increases from
2 to 4.
-Therefore, 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.
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
A Brief Look at the Adjustment Process
-Injection causes an increase in money supply causes excess supply of money. People get rid of their
excess money by spending it on good and services or by loaning it to others who spend it which results
in Increased Demand for Goods. But supply of goods does not increase = Prices must Rise
The Classical Dichotomy and Monetary Neutrality
-David Hume whom is a philosopher suggested that all economic variables should be divided into two
groups: Nominal and Real variables.
Nominal Variables: are measured in monetary units. Example: nominal GDP, nominal interest rate (rate
of return measured in $), nominal wage ($ per hour worked)
Dollar prices are nominal
Real Variables: are measured in physical units. Example: real GDP, real interest rate (measured in
output), real wage (measured in output)
Relative price of CD = price of CD/price of pizza = 1.5 pizzas per cd. They are measured in
physical units so they are real variables. Important Relative Price is real wage: W= nominal wage
(price of labor, 15/hour), P=price level ($5, unit of output), Real wage is the price of labor
relative to the price of output = W/P = 15/5 = 3 units of output per hour.
Classical Dichotomy: the theoretical separation of nominal and real variables
-monetary developments affect nominal variables but not real variables. If the BOC doubles the money
supply, all nominal variables including prices will double, all real variables including relative prices will
remain unchanged.
Monetary Neutrality: the proposition that changes in the money supply do not affect real variables.
Doubling money causes all nominal prices to double, but relative prices do not change because they are
real variables.
-Most economists believe the classical dichotomy and neutrality of money describe the economy in the
long run
Velocity and the Quantity Equation
Velocity of Money: the rate at which money changes hands = speed at which the typical dollar travels
around the economy from wallet to wallet
Calculation: Divide the nominal value of output (nominal GDP) by the quantity of money.
P x Y = nominal GDP = price level x real GDP
M= Money Supply
V=Velocity
V= (P x Y)/M
Example: Economy produces 100 pizzas in a year, pizza sells for $10, and the quantity of money in the
economy is $50: V= ($10 x 100)/$50 = 20
Quantity Equation: the equation M x V = P x Y, which relates the quantity of money, the velocity of
money, and the dollar value of the economy’s output of goods and services.
-It is called the quantity equation because it relates the quantity of money (M) to the nominal value of
output (P x Y).
-The quantity equation shows that an increase in the quantity of money in an economy must be
reflected in one of the other three variables: the price level must rise, the quantity of output must rise,
or the velocity of money must fall.
Quantity Theory in 5 Steps
1. The velocity of money is relatively stable over time
2. Because velocity is stable, when the central bank changes the quantity of money (M), it causes
nominal GDP (P x Y) to change by the same percentage
3. A change in M does not affect Y: money is neutral. Y is determined by technology and resources
4. P changes by same percentage as P x Y and M
5. Therefore, when the central bank increases the money supply rapidly, the result is a high rate of
inflation
Example: There is one good which is Corn. The economy has enough labor, capital, and land to produce
Y= 800 bushels of corn. V is constant. In 2008, MS= $2000, P=$5/bushel
-For 2009, the Bank of Canada increases MS by 5%, to $2100