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C H A P T E RC H A P T E R
13
Money and the Economy
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C H A P T E R 1 3 : M o n e y a n d t h e E c o n o m
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Money and the Price Level
• Do changes in the money supply affectsthe price level in the economy?
• Classical economists beloved so.
• Their position was based on the euationof e!change and the simple uantity theoryof money.
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C H A P T E R 1 3 : M o n e y a n d t h e E c o n o m
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C H A P T E R 1 3 : M o n e y a n d t h e E c o n o m
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Money and the Price Level "Continued#
• Equation of Exchange$ M% ≡ P&
• The money supply "M# multiplied by its%elocity "V# must be eual to the price level
"P# times 'eal (DP "Q#.
v e l o c i t y o f m o n e y
n o m i n a l G D P
m o n e y s u p p l y=
OR OR
Note: ≡ means “must be eual to!" this is an
identity#
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C H A P T E R 1 3 : M o n e y a n d t h e E c o n o m
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C H A P T E R 1 3 : M o n
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)nflation and the %elocity of Money
• The euation of e!change* or quantityequation, lin+s the money supply and velocityto nominal (DP$
• )f velocity is predictable* we can use theuantity euation and the supply of money topredict nominal (DP.
m o n e y s u p p l y v e l o c i t y n o m i n a l G D P x =
M ' P y x x=
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C H A P T E R 1 3 : M o n
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)nflation and the %elocity of Money
• The basic uantity euation can be used to derive a closely related formula for understanding inflation in the long run* called the growth version of thequantity equation$
• ,or e!ample$!ample$
Growth rateof the moneysupply
+Growthrate ofvelocity
=Growthrate ofprices
+Growth rateof real output
!" + !" =Growthrate ofprices
+ #"
$" = Growth rate of prices = inflation
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C H A P T E R 1 3 : M o n
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,rom the -uation of -!change to theimple &uantity Theory of Money
• The simple uantity theory of money assumes thatboth V and Q are constant.
• ,rom these assumptions* we have the simpleuantity theory of money$
• changes in M will bring aboutproportional changes in P.
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C H A P T E R 1 3 : M o n
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/ssumptions and Predictions of the imple&uantity Theory of Money
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C H A P T E R 1 3 : M o n
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The imple &uantity Theory in an /D0/,ramewor+
• M% is eual to total e!penditures.
• Total e!penditures is T- 1 C2)2(2"-30)M#
• ince M%1T-* M%1C2)2(2"-30)M#
• )n the simple uantity theory of money*velocity is assumed to be constant* so achange in money supply will changeaggregate demand and therefore lead to a
shift in the /D curve.
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C H A P T E R 1 3 : M o n
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The imple &uantity Theory in an /D0/,ramewor+ "Continued#
• )n the simple uantity theory of money* real(DP is fi!ed in short run. Thus* the /curve is vertical.
• /lso* in the simple uantity theory ofmoney* an increase in money supply willshift the /D curve rightward and increasesthe price level* and
• / decrease in the money supply will shift
the /D curve leftward and decreases theprice level.
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C H A P T E R 1 3 : M o n
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The imple &uantity Theory in an /D0/,ramewor+ "Continued#
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C H A P T E R 1 3 : M o n
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Dropping the /ssumptions that V and Q areConstant
• 'emember$ M ! % ≡ P ! &* then
P 1 M ! V
Q
• Money supply, velocity, and Real GDP determineMoney supply, velocity, and Real GDP determinethe Price Level.the Price Level.
• /n increase in M or V or a decrease in Q willcause prices to rise. This is inflation.
• / decrease in M or V or an increase in Q willcause prices to fall. This is deflation.
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C H A P T E R 1 3 : M o n
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Monetarism
• -conomists who emphasi4e the role thatthe supply of money plays in determiningnominal income and inflation are calledmonetarists. Today* most economists
agree with the monetarists that* in the longrun* inflation is caused by growth in themoney supply.
• Monetarists have not been content to rely
on the simple uantity theory of money.
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C H A P T E R 1 3 : M o n
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Monetarism$ 5ey %iews
6. %elocity changes in a predictable way.
7. /ggregate Demand depends on themoney supply and on %elocity.
8. The '/ curve is upward sloping.
9. The -conomy is elf0'egulating "Pricesand :ages are fle!ible#
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Monetarism in an /D0/ ,ramewor+
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The Monetarist %iew of the -conomy
• The economy is self0regulating
• Changes in velocity and the money supply canchange aggregate demand.
• Changes in velocity and the money supply willchange the price level and 'eal (DP in the shortrun* but only the price level in the long run.
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C H A P T E R 1 3 : M o n
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The Monetarist %iew of the -conomy
• Changes in velocity are not li+ely to offset changes in the moneysupply.
• Changes in the money supply will largely determine changes inaggregate demand* and therefore changes in 'eal (DP and the
price level.• /n increase in the money supply will raise aggregate demand
and increase both 'eal (DP and the price level in the short runand increase the price level "inflation# in the long run.
• / %ecrease in the money supply will lower aggregate demand
and decrease both 'eal (DP and price level "inflation# in theshort run and decrease price level in the long run.
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)nflation
• &nflation$ anyincrease in the price
level.• 'ne()hot &nflation$
one time increase inthe price level. Anincrease in the pricelevel that does notcontinue.
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;ne0hot )nflation$ Demand ide )nduced
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;ne0hot )nflation$ upply ide )nduced
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Continued )nflation ,rom ;ne0hot )nflation
Continued increases inaggregate demandcause continued
increases in inflation*or continued inflation.
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Changing ;ne hot )nflation )ntoContinued )nflation
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:hat Causes Continued )ncreases )n /ggregate Demand?
• The only factor that can change continually in sucha way as to bring about continued increases inaggregate demand is the money supplymoney supply.
• Money upply is the only factor that cancontinually increase without causing a reduction inone of the four components of total e!penditures$consumption "*#* investment "* governmentpurchases "G#* or net e!ports " M#.
M d ) t t ' t
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Money and )nterest 'ates:hat economic variables are affected by a change in
the money supply?
6. The supply of loans.
7. 'eal (DP
8. The price level
9. The e!pected inflationrate.
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Money and )nterest 'ates "Continued#
/ change in the money supply creates a change ininterest rates due to a change in$
• -iqui%ity Effect$ the supply of loanable funds.
• &ncome Effect$ 'eal (DP.• Price -evel Effect$ the price level.
• Expectations Effect$ the e!pected inflation rate.
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C H
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The )nterest 'ate and the Loanable ,undsMar+et
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C H
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:hat
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The =ominal and 'eal )nterest 'ates
• /ominal interest rate$ the interest rate actuallycharged "or paid# in the mar+et> the market interestrate.
• 1he 0eal &nterest 0ate$ the =ominal )nterest 'ateminus the -!pected )nflation 'ate.
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Coming p "Ch. 69#$ Monetary Policy
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C H
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/PP-=D)3
) fl ti d l t i th
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.. )nflation and nemployment in the6@ABs
• )n the early 6@ABs* high* real interest rateseventually caused the unemployment rate torise to over 6B by 6@A8.
• /s the actual unemployment e!ceeded thenatural rate of unemployment* the inflation ratefell* ust as was predicted by the e!pectationsPhillips curve. The severe recession had doneits ob in reducing the inflation rate.
Th D i f ) fl ti d
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C H
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The Dynamics of )nflation andnemployment* 6@AE06@@8
• /fter 6@AE* theunemployment rate beganto fall again* and as theactual unemployment fell
below the natural rate*inflation began to rise.
• )n 6@A@* the ,ed raisedinterest rates to combat
inflation. This reducedoutput and increasedunemployment to over Fby 6@@7.
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C H
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hifts in the =atural 'ate of nemployment
• The natural rate of unemploymentcan shift over time. The factors thatcause this include$
• Demographics* and the composition ofthe wor+force.
• )nstitutional changes* or changes inlaws and regulations that affect
unemployment benefits and restrictionsplaced on employers that ma+e itdifficult to fire wor+ers.
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C H
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hifts in the =atural 'ate of nemployment
• The natural rate of unemploymentcan shift over time. The factors thatcause this include$
• The state of the economy. Duringrecessions* wor+ers lose some of theirs+ills* which could lead to longer0termunemployment.
• Changes in the growth of laborproductivity. ne!pected productivitygrowth may be inconsistent withwor+ersG as+ing wages.
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C H
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C H
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C H
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early Monthly Growth 0ate
?olivia 7: ,:;,;!!" " 7"
5rgentina 77 #!;,;!! 7: 7#
/icaragua 7 7$:,:!! : 99
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C H
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C H
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Kudget Deficits and