Ch. 12 – Money Growth and Inflation

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Money Growth and Inflation12MacroeonomicsB R I E F P R I N C I P L E S O FN. Gregory MankiwPremium PowerPoint Slides by Ron Cronovich

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In this chapter, look for the answers to these questions:How does the money supply affect inflation and nominal interest rates? Does the money supply affect real variables like real GDP or the real interest rate? How is inflation like a tax? What are the costs of inflation? How serious are they?*

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and a quantity supplied of 600 … 78910111213Excess supplyDownward This table & graph indicate demand and supply conditions of the market for pocket calculators. Equilibrium will occur where the quantity demanded equals the quantity supplied. If the price in the market differs from the equilibrium level, market forces will guide it to equilibrium. A price of $12 in this market will result in a quantity demanded of 450 … resulting in an excess supply. With an excess supply present, there will be downward pressure on price to clear the market.Quick review of S & D Market EquilibriumPrice (dollars)Quantity supplied (per day)Quantity demanded (per day)12600450105505508500650Condition in the marketDirection of pressure on pricePrice ($)450500550600650QuantityDS

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and quantity demanded of 650… resulting in excess demand. 78910111213Excess supplyDownward A price of $8 in this market will result in quantity supplied of 500 … With an excess demand present, there will be upward pressure on price to clear the market.DSMarket EquilibriumPrice (dollars)Quantity supplied (per day)Quantity demanded (per day)12600450105505508500650Condition in the marketDirection of pressure on pricePrice ($)450500550600650QuantityExcess demandUpward

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and quantity demanded of 550 … resulting in market balance. A price of $10 in this market results in a quantity supplied of 550 …78910111213Excess supplyDownward With market balance present, there will be an equilibrium present and the market will clear.DSMarket EquilibriumPrice (dollars)Quantity supplied (per day)Quantity demanded (per day)12600450105505508500650Condition in the marketDirection of pressure on pricePrice ($)450500550600650QuantityExcess demandUpwardBalanceEquilibrium

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78910111213Excess supplyDownward At every price below market equilibrium there is excess demand and there will be upward pressure on the price level.DSMarket EquilibriumPrice (dollars)Quantity supplied (per day)Quantity demanded (per day)12600450105505508500650Condition in the marketDirection of pressure on pricePrice ($)450500550600650QuantityExcess demandUpward=BalanceEquilibrium At every price above market equilibrium there is excess supply and there will be downward pressure on the price level. At the equilibrium price, quantity demanded and quantity supplied are in balance.

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IntroductionThis chapter introduces the quantity theory of money to explain one of the Ten Principles of Economics from Chapter 1: Prices rise when the government prints too much money. Most economists believe the quantity theory is a good explanation of the long run behavior of inflation. 0

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The Value of MoneyP = the price level (e.g., the CPI or GDP deflator) P is the price of a basket of goods, measured in money. 1/P is the value of $1, measured in goods. Example: basket contains one candy bar. If P = $2, value of $1 is 1/2 candy bar If P = $3, value of $1 is 1/3 candy bar Inflation drives up prices and drives down the value of money. 0

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The Quantity Theory of MoneyDeveloped by 18th century philosopher David Hume and the classical economists Advocated more recently by Nobel Prize Laureate Milton Friedman Asserts that the quantity of money determines the value of money We study this theory using two approaches: A supply-demand diagram An equation0

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Money Supply (MS)In real world, determined by Federal Reserve, the banking system, consumers. In this model, we assume the Fed precisely controls MS and sets it at some fixed amount. 0http://www.nytimes.com/interactive/2008/05/03/business/20080403_SPENDING_GRAPHIC.html

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Money Demand (MD)Refers to how much wealth people want to hold in liquid form. Depends on P: An increase in P reduces the value of money, so more money is required to buy g&s. Thus, quantity of money demanded is negatively related to the value of money and positively related to P, other things equal. (These “other things” include real income, interest rates, availability of ATMs.) 0

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The Money Supply-Demand DiagramAs the value of money rises, the price level falls.0

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The Money Supply-Demand Diagram0

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The Money Supply-Demand DiagramA fall in value of money (or increase in P) increases the quantity of money demanded:0

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The Money Supply-Demand DiagramP adjusts to equate quantity of money demanded with money supply.0

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The Effects of a Monetary InjectionAThen the value of money falls, and P rises. Suppose the Fed increases the money supply.0

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A Brief Look at the Adjustment ProcessHow does this work? Short version: At the initial P, an increase in MS causes excess supply of money. People get rid of their excess money by spending it on g&s or by loaning it to others, who spend it. Result: increased demand for goods. But supply of goods does not increase, so prices must rise. (Other things happen in the short run, which we will study in later chapters.) Your Turn – Worksheet #1Result from graph: Increasing MS causes P to rise. 0

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The Inflation FairyEffects of Inflation Consider the effects of an overnight doubling of prices! While we all slept, the price of everything doubled: Soft drink was $1 – now sells for $2 A car sold for $20,000 – now sells for $40,000 The price of labor doubled as well: Job paying $6 per hour – now pays $12 per hour Annual salary of $30,000 – becomes $60,000 Value of Assets doubled as well: Stock prices are twice what they were yesterday $1,000 bond – now worth $2,000 A $35 balance in your checking account – now $70 Debts have also doubled: The $5 dollars borrowed from a roommate – now $10 $3,000 in student loans – now $6,000 A $75,000 home mortgage – becomes $150,000 Even Cash Balances doubled: Inflation fairy sneaks in and replaces the $10 bill in your wallet with a new $20 bill Even doubles coins in your piggy bank

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The Inflation FairyPoint of discussion: If the price of everything doubled overnight, what would happen? NOTHING! If all prices adjusted perfectly there would be no real effect. Everyone would have exactly the same purchasing power – you would have twice as much money, but everything costs twice as much. There have been no relative changes in price. The problem, of course, is that there is no inflation fairy ensuring that everything adjusts smoothly; some prices adjust quickly and other do not.

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Real vs. Nominal VariablesNominal variables are measured in monetary units. Examples: nominal GDP, nominal interest rate (rate of return measured in $) nominal wage ($ per hour worked) Real variables are measured in physical units. Examples: real GDP, real interest rate (measured in output) real wage (measured in output)0

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Real vs. Nominal VariablesPrices are normally measured in terms of money. Price of a compact disc: $15/cd Price of a pepperoni pizza: $10/pizza A relative price is the price of one good relative to (divided by) another: Relative price of CDs in terms of pizza:Relative prices are measured in physical units, so they are real variables. 0

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Real vs. Nominal WageAn important relative price is the real wage: W = nominal wage = price of labor, e.g., $15/hour P = price level = price of g&s, e.g., $5/unit of output Real wage is the price of labor relative to the price of output:= 3 units output per hour0

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The Classical DichotomyClassical dichotomy: the theoretical separation of nominal and real variables Hume and the classical economists suggested that monetary developments affect nominal variables but not real variables. If central bank doubles the money supply, Hume & classical thinkers contend all nominal variables – including prices – will double. all real variables – including relative prices – will remain unchanged. 0

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The Neutrality of MoneyMonetary neutrality: the proposition that changes in the money supply do not affect real variables Doubling money supply causes all nominal prices to double; what happens to relative prices? Initially, relative price of cd in terms of pizza isAfter nominal prices double, The relative price is unchanged.0

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The Neutrality of MoneySimilarly, the real wage W/P remains unchanged, so quantity of labor supplied does not change quantity of labor demanded does not change total employment of labor does not change The same applies to employment of capital and other resources. Since employment of all resources is unchanged, total output is also unchanged by the money supply.Monetary neutrality: the proposition that changes in the money supply do not affect real variables0

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The Neutrality of MoneyMost economists believe the classical dichotomy and neutrality of money describe the economy in the long run. In later chapters, we will see that monetary changes can have important short-run effects on real variables. 0

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Last Updated: 8th March 2018

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