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Chapter 4

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Maryann Vaughan

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Money and Inflation
In this chapter, we will learn
The classical theory of inflation (long-run)
o Causes
o Effects
o Social Costs
Classical assumes prices are flexible and markets clear
Applies to the long run
The Connection between Money and Prices
Inflation Rate the percentage increase in the average level of prices.
Price amount of money required to buy a good
Because prices are defined in terms of money, we need to consider the nature of money,
the supply of money, and how it is controlled.
Definition of Money
Money is the stock of assets that can be readily used to make transactions
Medium of exchange - we use it to buy things
o emphasizes that money makes exchange easier and more efficient
Store of value - transfers purchasing power from the present to the future
o People will hold money only if they believe it will continue to have value
Unit of Account - the common unit by which everyone measures prices and values
o Identifies the convenience of having a widely recognized measure for accounting
and transactions
Money: Types
Fiat Money - Has no intrinsic value
o Example: the paper currency we use
Commodity MoneyHas intrinsic value
o Example: gold coins (the value worth actually the money); cigarettes in P.O.W.
The Money Supply and Monetary Policy Definitions
The money supply is the quantity of money available in the economy
Monetary Policy is the control over the money supply

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The Central Bank
Monetary policy is conducted by a countrys central bank
In Canada, it is the Bank of Canada
Control of the Money Supply
This is one of the most important responsibilities of Canadas Central Bank, the Bank of
Decisions regarding the size of the money supply are the responsibility of the Governor of
the Bank of Canada
With input from the Federal Minister of Finance
And in constitute the governments monetary policy
The main method of control of the money supply is through open market operations = the
purchase of sale of outstanding government bonds (bonds already issued by the
government) by the Bank of Canada.
Open Market Operations
Increase the Money Supply Bank BUYS government bonds and securities from the
public, putting money in the circulation
Decreasing the Money Supply Bank SELLS government bonds and securities to the
public, taking money out of circulation
Note: Money held by the Bank of Canada is not included in the money supply
Types of Money
B, M1, M2, M2+, M3 -> remember the definitions
The Quantity Theory of Money
A simple theory linking the inflation rate to the growth rate of the money supply.
Begin with the concept of velocity
Basic Concept: The rate at which money circulates
Definition: The number of times the average loony changes hands in a given time period.
o  
o Where V = Velocity
T = value of All transactions
M = Money Supply

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The Quantity Equation
The Quantity Equation
o M x V = P x Y
o Follows from the preceding definition of velocity.
It is an identity; it holds by definition of the variables.
Start with the definition of velocity:
o   
Money Demand and the Quantity Equation
M/P = real money balances, the purchasing power of the money supply.
A simple money demand function: (M/P )d = k Y
where k = how much money people wish to hold for each dollar of income. (k is
Demand for Money
Assume the amount of money people wish to hold is proportional to income:
Md = k Y
(M/P )d = k Y
money demand: (M/P )d = k Y
demand for money: Md
dmand for real balances:(M/P)d
constant proportion of income: k
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