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11b Money and Inflation Introduction to Economics ETH Zürich, Prof. Dr. Jan-Egbert Sturm Winter Term 2006/07 General Information 24.10. Introduction; Transformation Curve, Opportunity Cost Mankiw ch.1,2 31.10. Markets: Demand and Supply Ch. 4 7.11. Elasticities Ch. 5 14.11. Costs, Production Function Ch. 13 21.11. Markets with perfect competiton Ch. 7, 14 28.11. Taxation Ch. 8 5.12. International Trade Ch. 9 12.12. Imperfect competition: Monopoly, and Oligoploy Ch. 15, 16 19.12. Public Goods, Externalities Ch. 10,11 9.1. National Accounting, Gross Domestic Product, Growth Ch. 23, 25 16.1. Money and Inflation Ch. 24, 29, 30 23.1. Business Cycles Ch. 33, 34 30.1. Open Economy Macro Ch. 31 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF The Classical Dichotomy and Monetary Neutrality • According to Hume and others, real economic variables do not change with changes in the money supply. • According to the classical dichotomy, different forces influence real and nominal variables. • Changes in the money supply affect nominal variables but not real variables. • The irrelevance of monetary changes for real variables is called monetary neutrality. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Velocity and the Quantity Equation • The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. V = (P Y)/M • Where: V = velocity P = price level Y = quantity of output M = quantity of money • http://www.wheresgeorge.com/ (US) • http://www.eurobilltracker.com/ (euro area) • http://www.cashfollow.ch/ (CH) Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Velocity and the Quantity Equation • Rewriting the equation gives the quantity equation: MV=PY • The quantity equation relates the quantity of money (M) to the nominal value of output (P Y). Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Velocity and the Quantity Equation • The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: • the price level must rise, • the quantity of output must rise, or • the velocity of money must fall. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF International data on inflation and money growth Inflation rate 10,000 (percent, logarithmic scale) 1,000 Democratic Republic of Congo Nicaragua Angola Brazil Georgia 100 Bulgaria 10 Germany Kuwait 1 USA Oman 0.1 0.1 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF 1 Japan 10 Canada 100 1,000 10,000 M oney supply growth (percent, logarithmic scale) U.S. data on inflation and money growth Inflation rate (percent) 8 1910s 1970s 1940s 6 1980s 4 1950s 1990s 2 0 1890s 1930s -2 -4 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research 1960s 1900s 1880s 1870s 1920s 0 KOF 2 4 6 8 10 12 Growth in money supp ly (p ercent ) Velocity and the Quantity Equation • The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money • The velocity of money is relatively stable over time. • When the SNB changes the quantity of money, it causes proportionate changes in the nominal value of output (P Y). • Because money is neutral, money does not affect output. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF THE COSTS OF INFLATION • A Fall in Purchasing Power? • Inflation does not in itself reduce people’s real purchasing power. • The costs of inflation • • • • • • Konjunkturforschungsstelle Swiss Institute for Business Cycle Research Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth KOF 12 Business Cycles Introduction to Economics ETH Zürich, Prof. Dr. Jan-Egbert Sturm Winter Term 2006/07 Short-Run Economic Fluctuations • Economic activity fluctuates from year to year. • In most years production of goods and services rises. • On average over the past 50 years, production in the U.S. economy has grown by about 3 percent per year. • In some years normal growth does not occur, causing a recession. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS • Economic fluctuations are irregular and unpredictable. • Fluctuations in the economy are often called the business cycle. • Most macroeconomic variables fluctuate together. • As output falls, unemployment rises. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Swiss GDP per capita (in 2002 US$, PPP) Quelle: GGDC, eigene Berechnungen 35,000 EU12 SDEC8 Schweiz 30,000 25,000 20,000 15,000 10,000 5,000 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Swiss GDP and KOF-Barometer Y-to-Y in % BFS: SNA 09/2006, Quartalisation: seco 5 3.0 2.4 4 KOF-Barometer 3 1.8 2 1.2 1 0.6 0 0.0 -1 -0.6 1999 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF 2000 2001 2002 2003 2004 2005 2006 2007 THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS • Most macroeconomic variables fluctuate together. • Most macroeconomic variables that measure some type of income or production fluctuate closely together. • Although many macroeconomic variables fluctuate together, they fluctuate by different amounts. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Swiss exports: Y-to-Y in % 16 BFS: SNA 09/2006, Quartalisation: seco Billion. Fr. (Quarter) KOF-Forecast 10/2006 64 12 60 8 56 4 52 0 48 7.0% 2.7% 3.3% -4 44 -8 40 2003 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF 2004 2005 2006 2007 2008 THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS • As output falls, unemployment rises. • Changes in real GDP are inversely related to changes in the unemployment rate. • During times of recession, unemployment rises substantially. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Employment vs. GDP (in Switzerland) 2.0 Employment 1.0 0 -1.0 -2.0 -3.0 -1.0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 Real GDP growth (2-years average) Quelle: BFS und KOF EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS • How the Short Run Differs from the Long Run • Most economists believe that classical theory describes the world in the long run but not in the short run. • Changes in the money supply affect nominal variables but not real variables in the long run. • The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF The Basic Model of Economic Fluctuations • Two variables are used to develop a model to analyze the short-run fluctuations. • The economy’s output of goods and services measured by real GDP. • The overall price level measured by the CPI or the GDP deflator. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF The Basic Model of Economic Fluctuations • The Basic Model of Aggregate Demand and Aggregate Supply • Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF The Basic Model of Economic Fluctuations • The Basic Model of Aggregate Demand and Aggregate Supply • The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF The Basic Model of Economic Fluctuations • The Basic Model of Aggregate Demand and Aggregate Supply • The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 2 Aggregate Demand and Aggregate Supply... Price Level Aggregate supply Equilibrium price level Aggregate demand 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Equilibrium output Quantity of Output THE AGGREGATE-DEMAND CURVE • The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 3 The Aggregate-Demand Curve... Price Level P P2 1. A decrease in the price level . . . 0 Aggregate demand Y Y2 2. . . . increases the quantity of goods and services demanded. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Quantity of Output Why the Aggregate-Demand Curve Is Downward Sloping • The Price Level and Consumption: The Wealth Effect • The Price Level and Investment: The Interest Rate Effect • The Price Level and Net Exports: The Exchange-Rate Effect Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Aggregate-Demand Curve Is Downward Sloping • The Price Level and Consumption: The Wealth Effect • A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. • This increase in consumer spending means larger quantities of goods and services demanded. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Aggregate-Demand Curve Is Downward Sloping • The Price Level and Investment: The Interest Rate Effect • A lower price level reduces the interest rate, which encourages greater spending on investment goods. • This increase in investment spending means a larger quantity of goods and services demanded. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Aggregate-Demand Curve Is Downward Sloping • The Price Level and Net Exports: The Exchange-Rate Effect • When a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, which stimulates U.S. net exports. • The increase in net export spending means a larger quantity of goods and services demanded. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Aggregate-Demand Curve Might Shift • The downward slope of the aggregate demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. • Many other factors, however, affect the quantity of goods and services demanded at any given price level. • When one of these other factors changes, the aggregate demand curve shifts. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Aggregate-Demand Curve Might Shift • Shifts arising from • • • • Konjunkturforschungsstelle Swiss Institute for Business Cycle Research Consumption Investment Government Purchases Net Exports KOF Shifts in the Aggregate Demand Curve Price Level P1 D2 Aggregate demand, D1 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Y1 Y2 Quantity of Output THE AGGREGATE-SUPPLY CURVE • In the long run, the aggregate-supply curve is vertical. • In the short run, the aggregate-supply curve is upward sloping. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF THE AGGREGATE-SUPPLY CURVE • The Long-Run Aggregate-Supply Curve • In the long run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. • The price level does not affect these variables in the long run. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 4 The Long-Run Aggregate-Supply Curve Price Level Long-run aggregate supply P P2 2. . . . does not affect the quantity of goods and services supplied in the long run. 1. A change in the price level . . . 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Natural rate of output Quantity of Output THE AGGREGATE-SUPPLY CURVE • The Long-Run Aggregate-Supply Curve • The long-run aggregate-supply curve is vertical at the natural rate of output. • This level of production is also referred to as potential output or fullemployment output. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Long-Run Aggregate-Supply Curve Might Shift • Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. • The shifts may be categorized according to the various factors in the classical model that affect output. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Long-Run Aggregate-Supply Curve Might Shift • Shifts arising • • • • Konjunkturforschungsstelle Swiss Institute for Business Cycle Research Labor Capital Natural Resources Technological Knowledge KOF Figure 5 Long-Run Growth and Inflation 2. . . . and growth in the money supply shifts aggregate demand . . . Long-run aggregate supply, LRAS1980 LRAS1990 LRAS2000 Price Level 1. In the long run, technological progress shifts long-run aggregate supply . . . P2000 4. . . . and ongoing inflation. P1990 Aggregate Demand, AD2000 P1980 AD1990 AD1980 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Y1980 Y1990 Quantity of Output 3. . . . leading to growth in output . . . Y2000 A New Way to Depict Long-Run Growth and Inflation • Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Aggregate-Supply Curve Slopes Upward in the Short Run • In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. • A decrease in the level of prices tends to reduce the quantity of goods and services supplied. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 6 The Short-Run Aggregate-Supply Curve Price Level Short-run aggregate supply P P2 2. . . . reduces the quantity of goods and services supplied in the short run. 1. A decrease in the price level . . . 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Y2 Y Quantity of Output Why the Aggregate-Supply Curve Slopes Upward in the Short Run • The Misperceptions Theory • The Sticky-Wage Theory • The Sticky-Price Theory Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Aggregate-Supply Curve Slopes Upward in the Short Run • The Misperceptions Theory • Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output: • A lower price level causes misperceptions about relative prices. • These misperceptions induce suppliers to decrease the quantity of goods and services supplied. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Aggregate-Supply Curve Slopes Upward in the Short Run • The Sticky-Wage Theory • Nominal wages are slow to adjust, or are “sticky” in the short run: • Wages do not adjust immediately to a fall in the price level. • A lower price level makes employment and production less profitable. • This induces firms to reduce the quantity of goods and services supplied. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF The Sticky-Price Theory • Prices of some goods and services adjust sluggishly in response to changing economic conditions: • An unexpected fall in the price level leaves some firms with higher-thandesired prices. • This depresses sales, which induces firms to reduce the quantity of goods and services they produce. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Why the Short-Run Aggregate-Supply Curve Might Shift • Shifts arising • • • • • Konjunkturforschungsstelle Swiss Institute for Business Cycle Research Labor Capital Natural Resources Technology Expected Price Level KOF Why the Aggregate Supply Curve Might Shift • An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the left. • A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the right. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 7 The Long-Run Equilibrium Price Level Long-run aggregate supply Short-run aggregate supply A Equilibrium price Aggregate demand 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Natural rate of output Quantity of Output Figure 8 A Contraction in Aggregate Demand 2. . . . causes output to fall in the short run . . . Price Level Long-run aggregate supply Short-run aggregate supply, AS AS2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . A P B P2 P3 1. A decrease in aggregate demand . . . C Aggregate demand, AD AD2 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Y2 Y 4. . . . and output returns to its natural rate. Quantity of Output TWO CAUSES OF ECONOMIC FLUCTUATIONS • Shifts in Aggregate Demand • In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. • In the long run, shifts in aggregate demand affect the overall price level but do not affect output. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF TWO CAUSES OF ECONOMIC FLUCTUATIONS • An Adverse Shift in Aggregate Supply • A decrease in one of the determinants of aggregate supply shifts the curve to the left: • Output falls below the natural rate of employment. • Unemployment rises. • The price level rises. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 10 An Adverse Shift in Aggregate Supply 1. An adverse shift in the shortrun aggregate-supply curve . . . Price Level Long-run aggregate supply AS2 Short-run aggregate supply, AS B P2 A P 3. . . . and the price level to rise. Aggregate demand 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research Y2 2. . . . causes output to fall . . . KOF Y Quantity of Output The Effects of a Shift in Aggregate Supply • Stagflation • Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation. • Output falls and prices rise. • Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF The Effects of a Shift in Aggregate Supply • Policy Responses to Recession • Policymakers may respond to a recession in one of the following ways: • Do nothing and wait for prices and wages to adjust. • Take action to increase aggregate demand by using monetary and fiscal policy. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Figure 11 Accommodating an Adverse Shift in Aggregate Supply 1. When short-run aggregate supply falls . . . Price Level Long-run aggregate supply P3 C P2 A 3. . . . which P causes the price level to rise further . . . 0 Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF 4. . . . but keeps output at its natural rate. Natural rate of output Short-run aggregate supply, AS AS2 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . AD2 Aggregate demand, AD Quantity of Output Summary • All societies experience short-run economic fluctuations around long-run trends. • These fluctuations are irregular and largely unpredictable. • When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. • According to the model of aggregate demand and aggregate supply, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • The aggregate-demand curve slopes downward for three reasons: a wealth effect, an interest rate effect, and an exchange rate effect. • Any event or policy that changes consumption, investment, government purchases, or net exports at a given price level will shift the aggregate-demand curve. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • In the long run, the aggregate supply curve is vertical. • The short-run, the aggregate supply curve is upward sloping. • The are three theories explaining the upward slope of shortrun aggregate supply: the misperceptions theory, the stickywage theory, and the sticky-price theory. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve. • Also, the position of the short-run aggregate-supply curve depends on the expected price level. • One possible cause of economic fluctuations is a shift in aggregate demand. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF Summary • A second possible cause of economic fluctuations is a shift in aggregate supply. • Stagflation is a period of falling output and rising prices. Konjunkturforschungsstelle Swiss Institute for Business Cycle Research KOF