ECN 301 Chapter Notes - Chapter 7: Nominal Interest Rate, Money Supply, Monetary Base

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5 Apr 2011
Department
Course
Professor
Intermediate Macroeconomics 1: Theory
Week 5
Chapter 7
Inflation
• In the 1970s, Canada experienced episodes of relatively mild (1 to 3%), creeping (4 to 7%) and
galloping (7 to 15%) inflation
• Inflation was at times large enough to cause significant economic and political trauma
– avoiding a repeat of the inflation of the 1970s remains a major goal of economic policy
The Flexible-Price Model
• The Classical dichotomy implies that real variables (real GDP, real investment spending, or the real
exchange rate) can be analyzed and calculated without considering nominal variables (price level)
– money is “neutral
• This is a special feature of the full-employment flexible-price model
Money
• is wealth that is held in a readily-spendable form
• is made up of
– coin and currency
– chequing account balances
– other assets that can be turned into cash or demand deposits nearly instantaneously, without risk or cost
The Usefulness of Money
• Without money, market transactions would have to be performed through barter
• In a barter economy, market exchange would require the coincidence of wants
– you would have to have some good or service that someone wants and he or she would have to have
some good or service that you want
• Money also serves as a unit of account
– money is used as a yardstick to measure value or quote prices
• Anything that alters the real value of money in terms of its purchasing power will also alter the real
terms of existing contracts that use the money as a unit of account
The Demand for Money
• Businesses and households have a demand for money
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– they want to hold a certain amount of wealth in the form of readily-spendable purchasing power to
carry out transactions
• a higher level of spending means a larger money demand
• There is a cost of holding money
– cash and chequing deposits earn little or no interest
• Opportunity Cost of Holding Money: the lost interest and profits, etc.
The Quantity Theory of Money
• assumes that the only important determinant of the demand for money is the flow of spending
• can be summarized using
– the Cambridge (England) money-demand function
M=1/V *(P*Y)
– the quantity equation
M*V= P*Y
(P * Y) represents the total nominal flow of spending
• M is the quantity of money
• V is a measure of how fast money moves through the economy
– how many times the average unit of money is used to buy a final good or service
Determining the Price Level
• In the flexible-price model of the macroeconomy
– real GDP (Y) is equal to potential GDP (Y*)
– the velocity of money is determined by the sophistication of the banking system
– the money supply is determined by the central bank
P= V/Y *M
• If the price level is lower than the quantity equation predicts
– households and businesses will have more wealth in the form of money than they wish
• they will increase purchases
– sellers will note demand is strong and raise prices
The Money Stock
• The Bank of Canada determines the money stock in Canada
– the determination of the money stock is the basic task of monetary policy
• The Bank of Canada can directly impact the monetary base
• To reduce the monetary base, the Bank of Canada sells short-term government securities
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Document Summary

Inflation: in the 1970s, canada experienced episodes of relatively mild (1 to 3%), creeping (4 to 7%) and galloping (7 to 15%) inflation, inflation was at times large enough to cause significant economic and political trauma. Avoiding a repeat of the inflation of the 1970s remains a major goal of economic policy. The flexible-price model: the classical dichotomy implies that real variables (real gdp, real investment spending, or the real exchange rate) can be analyzed and calculated without considering nominal variables (price level) Money is neutral : this is a special feature of the full-employment flexible-price model. Money: is wealth that is held in a readily-spendable form, is made up of. Other assets that can be turned into cash or demand deposits nearly instantaneously, without risk or cost. The usefulness of money: without money, market transactions would have to be performed through barter, in a barter economy, market exchange would require the coincidence of wants.

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