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ECON 305

Econ 2-20 Pxy=NGDP V= NGDP/M=PXY/M Quantity equation (equation of exchange) MV= PY (quantity equation) M/P= real money balances, the purchasing power of the money supply M/P= y/V Money supply is controlled by the Fed, we want to take it and adjust for prices d (M/P) =kY (money demand) K=1/V (connection b/w money demand and quantity equation) Where k= how much money people wish to hold for each dollar of income (its exogenous) (M/P) is the demand for real balances M ×V =P ×Y  When people hold lots of money relative to their incomes (k is large), money changes hands infrequently (V is small). Assume V is constant and exogenous… Leading to the Quantity Theory of Money How the price level is determined:  With V constant, the money supply determines nominal GDP (P Y ). ΔM ΔV ΔP ΔY + = + M V P Y  Real GDP (Y) is determined by the economy’s supplies of K and L and the production function (Chap 3). ΔM ΔY ΔP π = − π = M Y P  The price level is P = (nominal GDP)/(real GDP).   (Greek letter “pi”) denotes the inflation rate: The growth rate of a product equals the sum of the growth rates Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions, however money growth in excess of this amount leads to inflation Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. The quantity theory of money implies: 1. Countries with higher money growth rates should have higher inflation rates. 2. The long-run trend behavior of a country’s inflation should be similar to the long-run trend in the country’s money growth rate.  To spend more without raising taxes or selling bonds, the govt can print money.  The “revenue” raised from printing money is called seigniorage  The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money Real interest rate, r adjusted for inflation: r = i    Chap 3: S = I determines r .(S, I and r are real variables)  Hence, an increase in  causes an equal increase in i.  This one-for-one relationship is called the Fisher effect. Suppose V is constant, M is g
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