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ECN204 - Chapter 11 .doc

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ECN 204
Christos Shiamptanis

ECN204Chapter 11 NotesClassical Theory of InflationoInflation is an increase in the overall level of pricesHistorical AspectsOver the past 60 years prices have risen an average of about 4 per yearDeflation meaning decreasing average prices occurred in Canada in the twentieth centuryIn the 1970s prices rose by 7 per yearDuring the 1990s prices rose at an average rate of 2 per yearQuantity Theory of Money longrun determinants of the price level and the inflation rateInflation is an economywide phenomenon that concerns the value of the economys medium of exchangeWhen the overall price level rises the value of money fallsAn inverse relationship between the price level and the value of moneyoHyperinflation is an extraordinary high rate of inflationThe Value of MoneyoPPrice Level eg the CPI or GDP deflatorP is the price of a basket of goods measured in moneyo1P is the value of 1 measured in goodsoExample basket contains one candy barIf P2 value of 1 iscandy barIf P3 value of 1 is 13 candy baroInflation drives up prices and drives down the value of moneyThe Quantity Theory of MoneythoDeveloped by 18 century philosopher David Hurne and the classical economistsoAdvocated more recently by Nobel Prize Laureate Milton FriedmanoAsserts that the quantity of money determines the value of moneyoWe study this theory using two approaches1 A supplydemand diagram2 An equationMoney Supply MSoIn real world determined by Bank of Canada BoC the banking system consumersoIn this model we assume the BoC precisely controls money supply MS and sets it at some fixed amountMoney Demand MDoRefers to how much wealth people want to hold in liquid formoDepends 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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