ECN Ch. Money Growth and Inflation
The Classical Theory of Inflation
The Level of Prices and the Value of Money
• The first insight about inflation is that it is more about the
value of money than the value of goods.
• A rise in the price level means a lower value of money
because each dollar in your wallet now buys you a smaller
quantity of goods and services.
• Suppose P measures the number of dollars needed to buy a
basket of goods and services. The quantity of goods and
services that can be bought with $1 equals 1/P. 1/P is the
value of money measured in terms of goods and services.
Money Supply, Money Demand, and Monetary Equilibrium
• The demand for money is the amount of money reflects how
much wealth people want to hold in liquid form.
• The higher prices are, the more money typical transaction
requires, and the more money people will choose to hold in
their wallets and chequing accounts. That is, a higher price
level (a lower value of money) increases the quantity of
• In the long run, the overall level of prices adjust to the level
at which the demand for money equals the supply.
• If the price level is above equilibrium level, people will want
to hold more money than the Bank of Canada has created, so
the price level must fall to balance supply and demand. If the
price level is below the equilibrium level, people will want to
hold less money than the Bank of Canada has created, and
the price level must rise to balance supply and demand. At
the equilibrium price level, the quantity of money that people
want to hold exactly balances the quantity of money supplied
by the bank of Canada. • When value of money is high, price level is low
• When the value of money is low and the price level is high,
people demand a larger quantity of it to buy goods and
• Increase in the money supply makes dollars more plentyfull,
the result is an increase in price level that makes each dollar
The Effects of a Monetary Injection
• Quantity Theory of Money: A theory asserting that the
quantity of money available determines the price level and
the growth rate in the quantity of money available determines
the inflation rate.
A brief look at the Adjustment Process
• The immediate effect of a monetary injection is to create an
access supply of money.
• The injection of money increases demand for goods and
• The economy’s ability to supply goods and services,
however, has not changed.
• Thus, the greater demand for goods and services causes
prices of goods and services to increase.
The Classical Dichotomy and Monetary Neutrality
• Economic variables should be divided into two groups,
nominal variables and real variables
• Nominal variables: Variables measured in monetary units
• Real variables: Variables measured in the physical units
The real interest rate ( the nominal interest rate adjusted for
inflation) is a real variable because it measures the rate at
which the economy exchanges goods and services produced
today for goods and services produced in the future.
• Classical dichotomy: The theoretical separation of nominal
and real variables. • Monetary Neutrality: The proposition that changes in the
money supply do not affect real variables.
Changes in the supply of money, according to classical
analysis, affect nominal variables. When the central bank
doubles the money supply, the price level doubles, the
dollar wage doubles, and all the other values double. Real
variables, such as productions, employment, real wages
and real interest rates, are unchanged.
A similar change would occur if the government were to
reduce the length of the metre from 100 cm to 50 cm: As a
result of the new unit of measurement, all measured
distances (nominal variables) would double, but the actual
distances (real varibales) would remain the same. The
dollar, like the metre is merely a unit of measurement, so a
change in its value should not have important real effects.
• Relative price: The price the price of one thing compared to
another. Ex: the price of a tonne of corn is two tonnes of
wheat (physical units)
Velocity and the Quantity Equation
• Velocity of money: The rate at which money changes hands.
To calculate the velocity of money, we divide the nominal
value of output (nominal GDP) by the quantity of money.
If P is the price level (the GDP deflator), Y the quantity of
output (real GDP), and M the quantity of money, then
V = (P X Y)/ M
With slight algebraic rearrangements, this equation can be
rewritten as M X V = P X Y
• Quantity Equation: The equation M x V= P x Y, which
relates the quantity of money, and the dollar value of the
economy’s output of goods and services.
Its 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
• The elements necessary to explain the equilibrium price
level and inflation rate.
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 proportionate
changes in the nominal value of output (P x Y)
3. The economy’s output of goods and services (Y) is
primarily determined by factor supplies (labour, physical
capital, human capital, and natural resources) and the
available production technology. In particular, because
money is neutral, money does not affect output.
4. With output (Y) determined by factor supplies and
technology, when the central bank alters the money supply
(M) and includes pro