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Chapter 11

Money Growth and Inflation - Chapter 11.docx

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York University
ECON 1010
Frank Miller

Money Growth and Inflation - Hyper-inflation: extra-ordinary high rate of inflation The Classical Theory of Inflation Level of Prices and Value of Money - Inflation is more about the value of money than value of the goods - Rise in price level = lower value of money because each dollar now buys smaller quantity of goods/services - When prices rise, people have to pay more for their goods/services - If “P” is the price of goods/services measured in terms of money, 1/P is the value of money measured in terms of goods and services - When overall prices rise, value of money falls Money Supply, Money Demand and Monetary Equilibrium - Supply and demand for money determines its value o When BOC sells bonds, it receives dollars in exchange and contracts money supply o When BOC buys government bonds, it pays out dollars and expands money supply o If dollars deposited in banks, they can increase money supply even more; increased reserves - Demand depends on how much wealth people want to hold in liquid (currency) form o Depends on how much people rely on credit cards and whether automated teller machines are easy to find o If receiving high returns on interest bearing bond, savings is better idea o Average prices in the economy have great influence on demand for money o The higher the prices, the more money typical transactions require o Higher prices = more demand for money = lower value of money - In the long run, the overall level of prices adjusts to the level at which demand for money = supply - Price above equilibrium = people want to hold more money; price must fall - If price below equilibrium = people want to hold less money; price must rise - Money supply curve is vertical because BOC has fixed the quantity of money available - Demand curve slopes downwards: people want to hold larger quantity of money when each dollar buys less (price is low but value is high) Effects of Monetary Injection - When BOC increases supply of money; shifts supply curve to the right - Increase in supply makes dollars more plentiful, but increases price levels and makes each dollar less valuable - Quantity theory of money: quantity of money available determines price level and that growth rate in the quantity of money available determines inflation rate Adjustment Process - Effect of monetary injection is to crease excess supply of money - With the injection, people have more money in their wallets than they want o People might buy more goods/services o Might make loans to others by buying bonds or depositing into savings accounts o Loans allow other people to purchase goods/services o Overall, increases demand for goods/services - Economy’s ability to supply goods/services has not changed - When money is injected, available labour, physical capital, human capital, natural resources and technological change have not been altered - Causes price of goods/services to rise; increase demand for money because people using more dollars for every transaction - Overall price level eventually adjust to bring money supply and demand into balance Classical Dichotomy and Monetary Neutrality - Nominal variables: variables measured in monetary units o Income of corn farmers; it is measured in dollars o Nominal GDP; measures dollar value of economy’s output of goods/services - Real Variables: variables measured in physical units o Quantity of corn produced by farmers; because it is measured in tonnes o Real GDP; measures total quantity of goods and services produced and not influenced by current prices - Classical dichotomy: theoretical separation of nominal and real variables o Prices are normally quoted in terms of money and are nominal variables o Relative price: price of one thing compared to another  When comparing price of any two goods, dollar signs cancel and resulting number measured in physical units  Are real variables o Real wage: is a real variable because it measures rate at which economy exchanges goods/services for each unit of labour (adjusted for inflation) o Real interest rate: real variable because it measures the rate at which economy exchanges goods/services produced today for goods/services produced in the future - Nominal variables heavily influenced by developments in the economy’s monetary system - In the long run, quantity of money largely irrelevant for understanding determinants of important real variables - According to classical analysis; changes in money supply affect only nominal variables o When BOC doubles money supply, price level, dollar wage and other dollar values double o Production, employment real wages, and real interest rates are unchanged - Monetary neutrality: proposition that changes in money supply do not affect real variables Velocity and Quantity Equation - The rate at which money changes hands - V = (P x Y)/M o P: price level/GDP Deflator, Y: quantity of output/Real GDP, M: quantity of money - Tells how many times each dollar must change hands per year for certain spending to take place with certain quantity of money in the economy - Quantity equation: M x V = P x Y; relates the quantity of money, velocity of money and dollar value of economy’s output of goods/services o Shows that increase in quantity of money must result in
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