Chapter 11.docx

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Chapter 11: Money Growth and Inflation
Inflation: increase in overall level of prices
Deflation: prices fall
Hyperinflation: extraordinarily high rate of inflation
Quantity theory of money: prices rise when the government prints too much money
The Classical Theory of Inflation
The Level of Prices and the Value of Money
Enjoyment of a good has stayed the same, but the money used to buy a good has become
slightly less valuable
o More about the value of money than about the value of goods
Inflation is an economy wide phenomenon that concerns the value of the economy’s medium of
exchange
Price level rises
o People have to pay more for the goods and services they buy
o Also could mean a lower value of money b/c each dollar in your wallet now buys a
smaller quantity of goods and services
P = Price level
o G and S that could be bought with 1 dollar are 1/P
o 1/P is the value of money measured in terms of goods and services
o When overall price level rises, value of money falls
Money Supply, Money Demanded, Monetary Equilibrium
Money supply
o Ignore complications introduced in banking system, simply take the quantity of money
supplied as a policy variable
Money Demand
o How much wealth people want to hold in liquid form
o ‘Liquidity preference’
o The average level of prices in the economy important variable
Higher prices, more money the typical transaction requires and more money
people will hold in their wallets and chequing accounts
In the long run, the overall level of prices adjusts to the level at which the demand for money
equals the supply
When the value of money is high, the price level is low
Supply curve is vertical b/c the BOC has fixed the quantity of money available
Demand curve for money is downward sloping, when the value of money is low (and the price
level is high), people demand a larger quantity of it to buy goods and services
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The Effects of a Monetary Injection
Eg, gov’t buys gov’t bonds
Shift supply curve to the right
Value of money decreases
Equilibrium price level increases
Quantity theory of money: quantity of money available in the economy determines the vaue of
money, and growth in the quantity of money is the primary cause of inflation
A Brief Look at the Adjustment Process
Quantity of money supplied now exceeds the quantity demanded
The injection of money increases the demand for goods and services
Economy’s ability to supply goods and services have not changed
Price of goods and services to increase
Eventually reaches new equilibrium
The Classical Dichotomy and Monetary Neutrality
Nominal variables: variables measured into monetary units
Real variables: variables measured in physical units
o Nominal GDP measured in dollars, real GDP, total quantity of goods and services
produced
Classical dichotomy: separation of variables into these groups
Relative price: price of one thing compared to another
Dollar prices are nominal variables, whereas relative prices are real variables
Monetary neutrality: the proposition that changes in the money supply do not affect real
variables
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