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Chapter 11 Monetary Growth and Inflation

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Ryerson University
ECN 204
Paul Missios

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 p
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