Ch 13. Money And The Economy

Money And The Price Level Do changes in the money supply affect the

price level in the economy?

The equation of exchange. an identify that states that the “money

supply (M)” multiplied by “velocity (V)” must be equal to “the price level (P)” times “real GDP (Q).”

MV = PQ

Simple Quantity Theory Of Money The theory assumes that “velocity (V)”

and “real GDP (Q)” are constant, and predicts that changes in the “money supply (M)” lead to strictly proportional changes in “the price level (P).”

The Simple Quantity Theory Of Money In An AD-AS Framework The AD curve in the simple quantity theory of money: MV = total expenditure TE (total expenditure) = C + I + G + (EX – IM)

MV = TE MV = C + I + G + (EX – IM)

- a change in the money supply (M) or a change in velocity (V) will change aggregate demand and therefore lead to a shift in the AD curve.

The Simple Quantity Theory Of Money In An AD-AS Framework The AD curve in the simple quantity theory of money: - an increase in the money supply will increase aggregate demand and shift the AD curve to the right. - a decrease in the money supply will decrease aggregate demand and shift the AD curve to the left. - an increase velocity will increase aggregate demand and shift the AD curve to the right. - a decrease in velocity will decrease aggregate demand and shift the AD curve to the left

The AS Curve In The Simple Quantity Theory Of Money The level of real GDP is assumed to be

constant in the short run.

Exhibit 2 Page 277.

AD And AS In The Simple Quantity Theory Of Money Exhibit 2 Page 277.

Dropping The Assumption That V And Q Are ConstantInforms that the price level (P) depend on three variables:1. Money supply (M)2. Velocity (V)3. Real GDP (Q)

MV = PQP = (MV)/Q

Inflationary tendencies: M increases; V increases; Q decreases.Deflationary tendencies: M decreases; V decreases; Q increases.

Monetarist Views1. Monetarists do not assume velocity is constant. They assume that “velocity (V)” can

and does change.

2. Aggregate demand depends on the “money supply (M)” and on “velocity (V)”.

3. The SRAS curve is upward sloping.

4. The economy is self regulating (Prices and Wages are flexible).

Monetarism And AD-AS Exhibit 3 Page 280.

Exhibit 3(a) Page 280: - initially in long run: Qn, P1 - V constant, M increases from 800 to 820; AD increases. - Q1, P2, unemployment rate falls - Wage increases then SRAS decreases.

Monetarism And AD-AS

Exhibit 3(b) Page 280: - initially in long run: Qn, P1 - V constant, M decreases from 800 to 780; AD decreases. - Q1, P2, unemployment rate increases - Wage decreases then SRAS increases.

The Monetarist View Of The Economy1. Monetarists believe the economy is self

regulating2. Monetarists believe change in velocity

and the money supply can change aggregate demand.

3. Monetarists believe change in velocity and the money supply will change the price level and real GDP in the short run, but only the price level in the long run.

Inflation Increase in the price level.

2 types of increases in the price level: 1. A one shot increase. A one time increase in the price level. An increase in the price level that does not continue.

2. Continued increase. A continued increase in the price level.

One Shot Inflation

Year CPI

1 100

2 110

3 110

4 110

5 110

One Shot Inflation: Demand Side Induced Exhibit 4(a) Page 283.

Initially in long run equilibrium at point 1. Suppose AD1 moves to AD2. Economy moves to point 2 at P2.

At point 2, Real GDP is bigger than Natural Real GDP.

Means unemployment rate that exists is lower than the natural unemployment rate.

Workers paid higher wage rates. SRAS1 shifts to SRAS2

One Shot Inflation: Supply Side Induced Exhibit 5(a) Page 283.

Initially in long run equilibrium at point 1. Suppose SRAS1 moves to SRAS2 (because oil

prices increase). Economy moves to point 2 with P2. Real GDP is less than Natural Real GDP. Unemployment rate is greater than natural

unemployment rate. Workers paid lower wage. Causes SRAS2 moves to SRAS1.

Continued InflationYear CPI

1 100

2 110

3 120

4 130

5 140

From One Shot Inflation To Continued Inflation

Because of continued increases in AD (Exhibit 6 Page 285).

Money And Interest Rate What economic variables are affected by

change in the Money Supply? Those variables are:

1. Money and the supply loans. - open market purchase, the supply of loans rises. - open market sale, the supply of loans decreases.

Money And Interest Rate (continued) What economic variables are affected by

change in the Money Supply? Those variables are (continued):

2. Money and real GDP. - increases Money Supply, shifts AD rightward, produces higher level of real GDP.

Money And Interest Rate (continued) What economic variables are affected by

change in the Money Supply? Those variables are (continued):

3. Money and the price level.

The Money Supply, The Loanable Funds Market, And Interest Rate Exhibit 7 Page 289.

Demand for loanable funds: - downward sloping. - borrowers will borrow more funds as the interest rate declines.

The Money Supply, The Loanable Funds Market, And Interest Rate Exhibit 7 Page 289.

Supply for loanable funds: - upward sloping. - lenders will lend more funds as the interest rate rises.

The Money Supply, The Loanable Funds Market, And Interest Rate Exhibit 7 Page 289.

Surplus of loanable funds?

Shortage of loanable funds?

The Money Supply, The Loanable Funds Market, And Interest Rate Anything that affects either supply of

loanable funds or demand for loanable funds will affect the interest rate.

Changes in Money Supply (supply of loans, real GDP, the price level, expected inflation rate) affects supply or demand for loanable funds.

The Supply Of Loans Open market purchase increases reserves,

causes increases the supply of loanable funds.

Interest rate declines (liquidity effect) (Exhibit 7b Page 289)

Real GDP A change in Real GDP affects supply and

demand for loanable funds.

When Real GDP increases, both supply and demand for loanable funds increase (income effect) (Exhibit 7c Page 289).

The Price Level When the price level rises, The purchasing power of money falls, people may increase their demand for

credit (loanable funds) (price level effect) (Exhibit 7d Page 289).