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Chapter 11

Chapter 11

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ECON 1000
Troy Joseph

Chapter 11 Money Growth and Inflation • Inflation: increase in overall level of prices The Classical Theory of Inflation The Level of Prices and the Value of Money • Inflation is more about the money than about the value of goods • Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange • Suppose: o P = price level as measured by the CPI or GDP deflator o Then P measures number of dollars needed 2 buy basket of G&S o Quantity of G&S that can be bought with $1 = 1/P o If P is the price of G&S measured in terms of money, 1/P is the value of money measured in terms of G&S o WHEN OVERALL PRICE LEVEL RISES, VALUE OF MONEY FALLS Money Supply, Money Demand, and Monetary Equilibrium • Supply and demand determines the value of money • IN THE LONG RUN, THE OVERALL LEVEL OF PRICESADJUSTS TO THE LEVELAT WHICH THE DEMAND FOR MONEY EQUALS THE SUPPLY o If price level above equilibrium level, people want to hold more money than the bank has created so price level must fall 2 balance supply & demand o If price level below equilibrium level, people want to hold less money than the bank has created so the price level must rise 2 balance supply & demand The Effects of a Monetary Injection Chapter 11 Money Growth and Inflation • Economy in equilibrium but bank doubles supply of money by printing bills and dropping them from helicopters • When increase in money supply makes dollars more plentiful, result is increase in price level that makes each dollar less valuable • Quantity Theory of Money: quantity of money available determines price level and the growth rate in the quantity of money available determines inflation rate ABrief Look at the Adjustment Process • Immediate effect of monetary injection: create an excess supply of money • Get rid of excess supply of money: o Buy G&S with their excess holdings of money o Make loans 2 others by buying bonds or depositing the money into a bank savings account  allowing other people 2 buy G&S o BOTH increase demand for G&S • Greater demand 4 G&S causes prices of G&S to increase • The increase in the price level, increases the quantity of money demanded b/c people using more dollars for every transaction The Classical Dichotomy and Monetary Neutrality • Nominal Variables: variables measured in monetary units, dollar prices • Real Variables: variables measured in physical units, relative prices • Classical Dichotomy: separation of nominal and real variables • Relative Price: price of one thing compared to another ($ signs cancel out) • Different forces influence real and nominal variables • Changes in supply of money affect nominal variables but NOT real variables • Monetary Neutrality: changes in money supply do not affect real variables o Government changed 100 cm to 50 cm, nominal (measured) would double, but real (actual) would remain the same. Chapter 11 Money Growth and Inflation o This change won’t matter much in the long run but in the short run, would lead to confusion and mistakes Velocity and the Quantity Equation • How many times per year is the typical dollar used to pay for a newly produced G/S? • Velocity of Money: rate at which money changes hands (speed at which the typical dollar travels around the economy from wallet to wallet) • P = price level (GDP deflator) • Y = quantity of output (real GDP) • M = quantity of money • V = velocity o V = (P X Y)/M • M X V = P X Y o Quantity Equation o Relates quantity of money (M) to nominal value of output (P X Y) o Shows that an increase in the quantity of money in an economy must be reflected in one of 3 variables:
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