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ECN 301 (20)
David Lee (4)
Chapter 7

Week 5 Chapter 7

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Ryerson University
ECN 301
David Lee

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 www.notesolution.com – 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 www.notesolution.com • To increase the monetary base, the Bank of Canada buys short-term government securities • These transactions are called open market operations • The Bank of Canada directly controls the monetary base • The other measures of the money stock are determined by the interaction of the monetary base with the banking sector – regulatory requirements – the incentive of financial institutions to have enough funds on hand to satisfy depositors’ deman Inflation • The inflation rate is the proportional rate of change in the price level • the inflation rate will be (π = v+m- y) – v=growth rate of velocity – m=growth rate of the money stock – y=growth rate of real GDP Example – growth rate of real GDP=4% per year – growth rate of velocity=2% per year – growth rate of the money stock=5% per year •The bulk of changes in the rate of inflation are due to changes in the growth rate of the money stock – the growth rate of the money stock (m) can change quickly and substantially – changes in the growth rates of real GDP (y) and velocity (v) are generally smaller • Nevertheless, inflation is not always proportional to money growth • The most important reason: Velocity is not fixed, but is affected by the nominal interest rr+ . Money Demand, Money Supply and Money Market Equilibrium • Up until now we have not made a distinction between money supply and money demand. • The reason for this is that until now we have assumed that the money market always clears, that is money supply is always equal to money demand. Money Demand • Economic theory implies that money demand should be inversely related to the nominal interest rate – cash and chequing account balances earn – the purchasing power of money erodes at the rate of inflation www.notesolution.com – the expected real return on money is π e • The opportunity cost of holding money is the difference between the real rate of return on other assets (r) and the real rate of return on money(-π e) – the opportunity cost of holding money is the nominal interest rate [i=r+π e] • As the opportunity cost of holding money (i) rises, the quantity of money balances demanded falls Money Supply • The supply (or stock) of nominal money balances is determined by the Bank of Canada, and is denoted by Ms • Let us assume that the supply of nominal money balances is independent of the nominal interest rates. • The supply of real money balances Ms/P will then be independent of the nominal interest rate Money Market Equilibrium • The equilibrium in the money market is given by the equality of real money supply to real money demand: M s/P = Md/P = M/P Money, Prices, and Inflation • Suppose that the rate of growth of the money stock increases permanently – the inflation rate will rise – if
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