Transcript Ch. 28 Notes

Money Growth & Inflation
Inflation
• Measured by CPI or GDP Deflator
• During last 70 years, prices have risen on avg.
by about 4% per year
• Have been periods of deflation (late 1800s)
• Hyperinflation – extraordinarily high inflation
Classical Theory of Inflation
(Quantity Theory of Money)
• P (price level) is number of dollars needed to
buy a basket of goods & services
• 1/P is value of money measured in terms of
goods & services
• When price level rises, value of money falls
Value of Money
• Review of Money Supply & Money Demand
• In the long run, the overall level of prices
adjusts to the level at which the demand for
money equals the supply
Effects of a Monetary Injection
• When Fed increases MS, price level increases
while each dollar is less valuable
• Quantity Theory of Money: growth in quantity
of money is primary cause of inflation
Classical Dichotomy &
Monetary Neutrality
• Nominal variables (measured in monetary
units) vs. Real variables (measured in physical
units)
• Separation of two sets of variables is called
the classical dichotomy
• Dollar prices are nominal, relative prices are
real
• Monetary Neutrality: changes in money
supply do not affect real variables
• Pretty good description of how things work in
the long run
Velocity & the Quantity Equation
• Velocity of Money – rate at which money
circulates throughout the economy
• V = (P x Y)/M Divide nominal GDP by
quantity of money
• Also can be written: M x V = P x Y and this is
called the “quantity equation”
• Velocity is often assumed to be constant
Explanation of Equilibrium Price Level
& Inflation Rate
1. Velocity of $ is relatively stable
2. When quantity of $ changes (M), it causes
proportionate changes in nominal value of
output (P x Y)
3. Economy’s output (Y) is primarily determined
by factor supplies & technology available, not
by money
4. When money supply (M) changes it is
reflected in changes in price level (P)
5. Therefore, when Fed changes money supply
rapidly, the result is high inflation
3 Views
1. Classical: Assumes Y & V are fixed, so
expansionary policy can only lead to inflation
2. Keynesian: Don’t believe Y & V are fixed, don’t
trust the effectiveness of monetary policy and
instead emphasize fiscal policy
3. Monetarists: Demand for money is stable,
expansionary monetary policy creates surplus of
money & can increase real GDP but in long run it
only leads to inflation
- Fixed money supply rule: equal to real growth rate
Inflation Tax
• When the government raises revenue by
printing money – like a tax on anyone who
holds money
THE FISHER EFFECT
• Remember:
Real Interest Rate = Nominal interest rate –
inflation
• When the Fed increases the rate of money
growth, the result is both a higher inflation
rate and a higher nominal interest rate