Transcript Lecture 16

L11200 Introduction to Macroeconomics 2009/10
Lecture 16:
Money and the Price Level I
Reading: Barro Ch.10
2 March 2010
Introduction
• Last time:
– Completed Economic Fluctuations topic by
explaining fluctuations in unemployment
– Arise due to natural unemployment rate varying
over the business cycle
• Today
– Begin new topic on money
– Consider money demand and supply
Where are we going
• Want to incorporate money demand in to the
model
– So far ignored the issue: assumed that household
held a constant amount of money used to fund
transactions
• Understand pattern of prices and inflation
– History suggests price variation can change
radically
– Controlling inflation has been a key policy issue for
modern governments
Money
• People get confused about money
– Think outcomes of models will change when we
introduce money
– Silly ideas around, such as the idea that banks can
‘create’ money
– Disconnect the ‘monetary economy’ from the
model of output, incomes, wages etc
– Real story is actually much more simple
Concepts of Money
• Without money, you have barter
– People exchange goods for goods
– Complicated, messy and inconvenient
• Money is a medium of exchange
– Households are willing to accept money in lieu of
goods and services: money stores value
– Households can access this value when they want
to by exchanging it for goods / services
Concepts of Money
• Money itself is just paper: ‘fiat money’
– Historically, people have used valuable
commodities as money (e.g. gold) because of lack
of legal enforcement of fiat money
– Use ‘commodity money’ so if society non longer
recognises value of commodity as money, it has
some intrinsic value (e.g. as gold)
– Commodity money is a waste of resource
– We will only consider fiat money
Money Demand
• There is an opportunity cost to holding money
– It could be invested in bonds or capital
– But you need it to carry out transactions (buy
goods, new capital, new bonds)
– Trade-off: if you hold more money, you have it
available for transactions and don’t need to incur
the cost of going to the bank so often
– If you hold less money, you earn more interest at
the bank
Money Demand
• What affects this decision
– Interest rate: if the interest rate is higher, you
want to hold less money and put more in the bank
(where it earns interest)
– Price level: if prices are higher, you need more
money to service transactions
– Output: if you have more output (income), you
need more money to exchange the higher level of
output
Money Demand Function
• So we can establish a general function
M d  P  L(Y , i)
• Often express this in real terms. If prices
double, money held doubles, so in real terms
no change occurs:
M / P  L(Y , i )
• Empirical studies suggest this is accurate
Equilibrium Price Level
• What about supply of money?
– Money supply is fixed by the government.
– They print a certain amount of money so that
transactions can take place easily
– Needs to be divisible (so prices can be easily
divisible)
– So price of goods change due to changes in
demand and supply
Ms=Md
• Changing money supply changes the price
level in the economy
– E.g. government doubles amount of printed
money in economy and distributes it randomly
– Everyone has more nominal money, demand for
everything doubles
– Prices double, wages doubles, rents double
– So in real terms nothing changes
– Money is neutral, hence term ‘money neutrality’
Money Neutrality
• This is essentially a simple idea
– Money is just paper currency. The price of a good
in isolation doesn’t mean anything, it is only the
price of one good relative to another that matters
– So if everyone is given more money (but continues
to buy the same goods) all prices double
– Relative prices are unchanged.
– Nothing has changed
Money Illusion
• This would not be the case if
– People got confused between the nominal value
(£) of things and the real value
– E.g. people only worry about their wage in £
– When prices double, they don’t realise that their
wages are worth less, so don’t negotiate
– This is called money illusion
Summary
• Created model of money demand and supply
– Trade-off between holding money and buying
bonds instead
– When prices rise, money holdings rise 1:1, so no
effect on real money balance
– When money supply rises, prices rise 1:1, all real
variable unchanged, no effect on activity
• Next time: Examine changes in money
demand