Download Money Growth and Inflation

Introduction to Macroeconomics
Chapter 17
Money Growth and Inflation
Price Level and Value of Money
• When the price of a good rises – people need
more money to pay for it
• Since they need more money to buy the same
good – the value of each dollar declines
As prices rise  value of money falls
P = Price Level
1/P = Value of Money
Understanding Quick Check
Your favorite coffee beverage costs you $4 per cup.
Your value of money is ____. One day, you go into your
favorite coffee shop and the coffee now costs $5. Your
value of money now is ____ and you are ____.
a) ¼, 1/5, better off
b) ¾, 4/5, better off
c) ¼, 1/5, worse off
d) ¾, 4/5, worse off
Money Supply and Money Demand
• Money supply (MS) is determined mainly by
the Federal Reserve
– Quantity of money is fixed
• Money demand (MD) reflects how much
wealth people want to hold in a liquid form
– Main determinant: Price level
– At high prices – people need to hold more money
in liquid form for their transactions
– MD is high when value of money is low
Money Equilibrium
Prices adjust to bring MD = MS
People will adjust how much money they must hold in response to price change
Money Equilibrium
Prices adjust to bring MD = MS
People will adjust how much money they must hold in response to price change
Money Equilibrium
Prices adjust to bring MD = MS
People will adjust how much money they must hold in response to price change
Application 1
Suppose the Fed decides to increase the money supply
through open market operations. It decides to buy
bonds from the public.
• Graph the Md-Ms diagram
• Illustrate the change this policy will have on the
money market.
• What happens to the new equilibrium price level,
value of money and equilibrium quantity of money?
• In the interim (before price level adjusts), is there a
surplus or shortage of money?
Coping with Surplus of Money
When there is a surplus of money, people try to get rid of it:
1. Buying more goods and services  Increase in
demand
2. Putting money in the loanable funds market  more
loans available  Increase in demand for goods
Both cases:
Increase in demand leads to increase in prices
↑MS = ↑ demand = ↑ prices
Application 2.a
Suppose credit cards become more readily available to the
general adult population, making it easier to purchase
goods and services without carrying cash around
everywhere.
• Graph the Md-Ms diagram
• Which curve shifts and why?
• Illustrate the change this will have on the money market.
• What happens to the new equilibrium price level, value
of money and equilibrium quantity of money?
Application 2.b
In response to the previous scenario, the Fed becomes
concerned about inflation and prefers to keep the price
level at P* (original price level).
• What can the Fed do with the money supply to impact
the money market?
• On a new graph, illustrate this change and discuss what
happens with the value of money, inflation, and
quantity of money
Classical Dichotomy
Refers to the separation of nominal and real variables
• Nominal Variables: Measured in monetary terms
The price of an apple is $2
The price of a banana is $1
• Real Variables: Measured in physical units (or relative terms)
The price of an apple is 2 bananas
The price of a banana is ½ apple
Changes in the money supply – Nominal changes
Monetary Neutrality: Changes in the money supply will
not impact real variables
The Velocity of Money
Velocity of money: the rate at which money changes hands
Notation:
PxY
= nominal GDP
= (price level) x (real GDP)
M
= money supply
V
= velocity
Velocity of money :
PxY
V =
M
Quantity Equation :
MxV = PxY
Application 3
Suppose we have the following values:
Y = $5000; V = 5; M = $2000; P = 2
• Calculate the quantity equation
• If money supply increases to $3000, how would prices change to keep the
quantity equation true?
• If money supply increases to $3000, how would real GDP change to keep
the quantity equation true?
• If money supply increases to $3000, how would velocity change to keep
the quantity equation true?
• Which variables do we know will not change (based on monetary
neutrality)?
• Which variable do you think must change in response to the change in
money supply?
Fischer Effect
• Nominal interest rates adjust one-for-one to
the inflation rate
Real i = nominal i – inflation
• Change in inflation  impacts nominal
interest rate not real interest rate
• Important implications for taxing interest
income, debt repayment, and savings
Application 4
Suppose Country A and Country B both set taxes on interest
income to 20%. Country A’s inflation is 1%, Country B’s inflation
is 10%. Complete the following table:
Country A
Country B
Real Interest Rate
3%
3%
Inflation Rate
1%
10%
Nominal Interest Rate
Reduction in Nominal
Interest from 20% tax
After-tax Nominal Rate
After-tax Real Rate
Which country is likely to have lower savings rates?
Application 5
Suppose a student has $20,000 of debt with a 7% nominal interest
rate. The debt compounds over 10 years.
• What is the nominal value of that debt?
• What is the real value of that debt if….
• Inflation is very high (20%)?
• If there is deflation (-20%)?
• Is inflation good for borrowers or lenders?
• Is deflation good for borrowers or lenders?
Key Takeaways
• Money growth influences price levels and inflation in
the economy
• Since money is a nominal variable, changes in MS it will
have no impact on real variables such as real GDP,
unemployment, relative prices, ect.
• Can use both the MD-MS graph and quantity equation
to describe this relationship
• Inflation is costly, but deflation is worse!