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Chapter 11

ECO1102 Chapter 11: Inflation
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Department
Economics
Course Code
ECO1102
Professor
David Gray

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ECO 1102 ― Chapter 11: Money Growth and Inflation The Classical Theory of Inflation The Level of Prices and the Value of Money ● Inflation is more about the value of money than the value of goods ○ Theory of Inflation ● Inflation is an economy-wide phenomenon that’s concerned with the value of an economy’s medium of exchange ● Two ways of viewing an economy’s overall price level: ○ Price level as a basket of goods and services ○ Price level as a value of money ■ A rise in the price value results in a lower value of money ● Mathematically: ○ Suppose P is price level measured in terms of CPI or the GDP Deflator ○ 1/P is the quantity of goods and services that can be bought with $1 ■ Value of money measured in terms of goods and services ● Therefore, when overall price level rises, the value of money falls Money Supply, Money Demand, and Monetary Equilibrium ● Supply and demand determine the value of money ● Money Supply ○ Bank of Canada issues or retracts money by using its tools ● Money Demand ○ Depends on how much wealth people want to hold in liquid form → Liquidity Preference ○ Ex) The amount of currency people hold in their wallets depends on how much they rely on credit cards and their accessibility to an ATM ○ The key variable affecting money demand is the average price levels of the economy ■ The money people choose to hold depends on the price of goods and services ○ Higher price level increases the quantity of money demanded ● To figure out how to achieve equilibrium, you must first determine if its short or long term ○ Long Run: Overall price levels adjust to the level where money demand equals supply ■ Price Level Above Equilibrium: People will hold their money; price level must fall ■ Price Level Below Equilibrium: People will hold less money; price level must rise ECO 1102 ― Chapter 11: Money Growth and Inflation The Effects of Monetary Injection ● An increase in the money supply causes an increase in price levels, leading to a decrease in the value of money ● This effect is apparently known as the quantity theory of money: ● Quantity of money determines the value of money, and growth in the quantity causes inflation A Brief Look at the Adjustment Process ● How does an economy get a new equilibrium? ○ Monetary injection causes an excess in the money supply ○ Quantity Supplied > Quantity Demanded ○ People will either spend on goods and services or save (which will later be spent) ECO 1102 ― Chapter 11: Money Growth and Inflation ■ The injection increases the demand for goods and services ○ Since the supply for goods and services doesn’t increase, goods and services’ prices increase ● Patterns: ○ Greater demand for goods and services causes the prices of goods and services to increase ■ The increase in the price level Increases the quantity demanded ● Money Supplied = Money Demanded The Classical Dichotomy and Monetary Neutrality ● 2 Types of Economic Variables ○ Nominal Variables → measured in monetary units ○ Real Variables → measured in physical units ■ Classical Dichotomy ■ Relative Price → the price of one thing compared to another ■ Ex) The real wage measures the rate at which the economy exchanges goods and services for each unit of labour ■ Ex) The real interest rate measures the rate at which the economy exchanges goods and services produced today for goods and services produced in the future ● Why do we separate them? ○ For analyzing the economy because different forces affect nominal and real variables ■ Nominal variables are influenced by monetary activities ● Monetary Neutrality → the irrelevance of monetary changes for real variables in the long-run ● In the short-run, monetary changes leads to confusion ○ There are some effects on real variables ● In the long-run, it doesn’t matter ● Long-run: Neutrality of money offers a good description of how the world works Velocity and the Quantity Equation ● How many times per year is the typical dollar used to pay for a newly produced good or service ○ Velocity of Money → The speed at which the typical dollar travels around the economy from wallet to wallet ○ Divide nominal GDP by the quantity of money ○ P is price level, Y is real GDP/Quantity of output, M is the quantity of money: 𝑉×𝑉 𝑉 = 𝑉 ECO 1102 ― Chapter 11: Money Growth and Inflation ● Quantity Equation: 𝑉×𝑉 = 𝑉×𝑉 ● Relates the quantity of money to the nominal value of output ● If the quantity of money increases, then: ○ The price level must rise ○ The quantity of output must rise ○ The velocity of money must fall ● Velocity of money is not usually constant ● Read The list The Inflation Tax ● Governments create hyperinflation because they think creating money is a good way to pay off their debts ● Inflation Tax → when the government raises revenue by printing money. It’s a subtle tax ○ Ex) When governments print money, the price level goes up and the value of money goes down ● The inflation tax is like a tax on everyone who holds money ● <1% of the Canadian government’s revenue ● Hyperinflation is resolved when the government institutes fiscal reforms ○ Cuts in government spending The Fisher Effect ● Principle of monetary neutrality that states that an increase in the rate of money growth raises the rate of inflation, while not affecting any real variables ○ Concerns the effects of money on the interest rate ○ NOTE: Nominal inflation is what you hear at the bank 𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉 = 𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉 − 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉 Also, 𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉 = 𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉 + 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉 ● Money Supply’s effect on interest rate: ○ In the long run, when money is neutral, a change in the money supply won’t
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