ECON 1000 Chapter Notes - Chapter 11: Cash Machine, Overnight Rate, Economic Equilibrium
2 May 2018
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ECON 1000
Chapter 11: Money Growth and Inflation
The Level of Prices and the Value of Money:
• When the price level rises, people have to pay more for the goods and services they buy
• We can 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
• When the overall price level rises, the value of money falls
• Supply and demand determines the value of money
• The Bank of Canada, together with the banking system, determines the supply of money
• When it increases the overnight rate, the Bank of Canada discourages banks from
borrowing reserves from it, an increase in the overnight rate reduces the quantity of
reserves in the banking system, which reduces the money supply
• A lower overnight rate encourages banks to borrow from the Bank of Canada, increases
the quantity of reserves, and increases the money supply
• If the Bank of Canada sells bonds in an open-market operation, it receives dollars in
exchange and contracts the money supply
• If instead it buys bonds in an open-market operation, the Bank of Canada pays out
dollars and expands the money supply
• The demand for money reflects how much wealth people want to hold in liquid form
• Many factors influence the quantity of money
• The amount of currency that people hold in their wallets, depends on how much they
rely on credit cards and on whether an automated teller machine is easy to find
• The quantity of money demanded depends on the interest rate that a person could earn
by using the money to buy an interest-bearing bond rather than leaving it in a wallet or
low-interest chequing account
• The higher prices are, the more money the typical transaction requires, and the more
money people will choose to hold in their wallets and chequing accounts
• A higher price level (lower value of money) increases the quantity of money demanded
• In the long run, the overall level of prices adjusts to the level at which the demand for
money equals the supply
• If the price level is above the 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
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How the Supply and Demand for Money Determine the Equilibrium Price Level:
• The horizontal axis shows the quantity of money
• The left vertical axis shows the value of money, and the right vertical axis shows the
price level
• The supply curve for money is vertical because the quantity of money supplied is fixed
by the Bank of Canada
• The demand curve for money is downward sloping because people want to hold a larger
quantity of money when each dollar buys less
• At the equilibrium, point A, the value of money (on the left axis) and the price level (on
the right axis) have adjusted to bring the quantity of money supplied and the quantity of
money demanded into balance
The effects of a Monetary Injection:
An increase in the Money Supply:
• When the Bank of Canada increases the supply of money, the money supply curve shifts
from MS1 to MS2
• The value of money (on the left axis) and the price level (on the right axis) adjust to
bring supply and demand back into balance
• The equilibrium moves from point A to point B
• When an increase in the money supply makes dollars more plentiful, the price level
increases, making each dollar less valuable
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• 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
• The immediate effect of a monetary injection is to create an excess supply of money
• Before the injection, the economy was in equilibrium
• At the prevailing price level, people had exactly as much money as they wanted
• At the prevailing price level, the quantity of money supplied now exceeds the quantity
demanded
• People try to get rid of this excess supply of money in various ways
• They might buy goods and services with their excess holdings of money, or they might
use this excess money to make loans to others by buying bonds or by depositing the
money into a bank savings account, these loans allow other people to buy goods and
services
• The injection of money increases the demand for goods and services
• The eooy’s aility to supply goods ad series does ot hage
• The greater demand for goods and services causes the prices of goods and services to
increase
• The increase in the price level, increases the quantity of money demanded because
people are using more dollars for every transaction
• The economy reaches a new equilibrium at which the quantity of money demanded
again equals the quantity of money supplied
• The overall price level for goods and services adjusts to bring money supply and money
demand into balance
• Economic variables should be divided into two groups :
o Nominal variables: variables measured in monetary units
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Document Summary
If the bank of canada sells bonds in an open-market operation, it receives dollars in exchange and contracts the money supply. In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply. If the price level is above the 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. 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. I(cid:374)flatio(cid:374) does (cid:374)ot i(cid:374) itself redu(cid:272)e people"s real pur(cid:272)hasi(cid:374)g po(cid:449)er. Inflation increases the menu costs that firms must bear. Relative-price variability and the misallocation of resources: suppose that the eatabit eatery prints a new menu with new prices every january and then leaves its prices unchanged for the rest of the year.
