Download Value of Money

Mid-Term February 15
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MC in-class
30 questions, 3.3 marks each
Plus 1 free mark!!
Covers chapters 5-11.
Principles of Macroeconomics:
Unemployment-US data
LF = 157 million
• 1st 3 months of 2010
• 311,000 jobs lost-NET
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Gross flows are huge-dynamic effects
∑ job losses= 6,421,000
jl
∑ job gains = 6,110,000
jg
These flows are always large.
U declines when jg>jl and VV
Jl >>1,190,000 closed, 5,231,000 reduced E
Jg>>1,114,000 new, 4,996,000 expansions
Overview--11
• The causes of inflation
• Money supply, demand and
equilibrium
• The effects of monetary growth
• The quantity theory of money
• The inflation tax
• The costs of inflation
Inflation: Its Causes and
Costs
• Inflation is a sustained increase
in the price level. It is a
continuous increase versus a
“once-and-for-all” increase in
prices.
• Inflation deals with the increase
in the average of prices and not
just significant increases in the
price of a few goods.
Principles of Macroeconomics:
Inflation: Historical
Aspects
• Over the past sixty years, prices
have risen on average about 4
percent per year.
• Deflation, a situation of decreasing
prices, occurred in the nineteenth
century.
• In the 1970’s prices rose by 7
percent per year. Doubles in 10 yrs.
• From 1990 to 2007 prices rose about
2 percent per year.
Principles of Macroeconomics:
Inflation: Historical
Aspects
• Over the past sixty years, prices
have risen on average about 4
percent per year.
• Deflation, a situation of decreasing
prices, occurred in the nineteenth
century.
• In the 1970’s prices rose by 7
percent per year. Doubles in 10 yrs.
• From 1990 to 2007 prices rose about
2 percent per year. Double in 35
Principles of Macroeconomics:
The Value of Money
• P = the price level
(e.g., the CPI or GDP deflator)
P is the price of a basket of goods,
measured in money.
• 1/P is the value of $1, measured in goods.
• Example: basket contains one candy bar.
• If P = $2, value of $1 is 1/2 candy bar
• If P = $3, value of $1 is 1/3 candy bar
• Inflation drives up prices, and drives down
the value of money.
The Causes of Inflation
• Inflation is an economy-wide
monetary phenomenon that
concerns, first and foremost, the
value of an economy’s medium of
exchange.
• To understand the cause of inflation
as a monetary phenomenon we must
understand the concepts of Money
Supply, Money Demand, and
Monetary Equilibrium.
Principles of Macroeconomics:
Money Supply and Money
Demand
• Money Supply is determined by the
Bank of Canada. Through
instruments such as open market
operations, the B of C directly
controls MS
• Money Demand by the public has
several determinants including:
• interest rates and prices in the
economy
Principles of Macroeconomics:
Money Supply and Money
Demand
• People hold money because it is the
medium of exchange. The amount of
money people choose to hold
depends on incomes and the prices
of the goods and services.
• In the long-run, the overall level of
prices adjusts to the level at which
the demand for money equals the
supply.
Principles of Macroeconomics:
Money and Prices (Price
axis reversed)
Value of
Money
Money Supply
Equilibrium
Price Level
Equilibrium
Value of
Money
Money
Demand
Qfixed by B of C
Principles of Macroeconomics:
Price
Level
Monetary Equilibrium
• The B of C could inject money
(monetary injection) into the economy
by buying government bonds. Results
would be:
• The M supply curve shifting to the right
• The equilibrium value of money decreasing
• The equilibrium price level increasing
• This process is referred to as the
quantity theory of money.
Principles of Macroeconomics:
2 items
• Value of M = 1/P
• 1/P is the value of $1, measured
in goods.
• In the diagram, the price (right
side) axis is reversed. The
HIGH price level is at the
bottom and LOW at the top.
Monetary Injection
Value of
Money
(High)
MS1
Price
Level
(Low)
PE
VME
Money
Demand
Low
QFixed
Principles of Macroeconomics:
High
Monetary Injection
Value of
Money
(High)
MS1 MS2
PE
VME
VME
Money
Demand
Low
QFixed
Principles of Macroeconomics:
Price
Level
(Low)
PE
High
Cause of Inflation:
The Quantity Theory of
Money
• The quantity of money available
in the economy determines the
value of money. Growth in the
quantity of money is the primary
cause of inflation.
• Some macroeconomic variables
are unchanged, given changes
in the supply of money.
Principles of Macroeconomics:
Real vs. Nominal
Variables
• Nominal variables are measured in
monetary units.
examples: nominal GDP,
nominal interest rate (rate of return measured
in $)
nominal wage ($ per hour worked)
• Real variables are measured in physical
units.
examples: real GDP,
real interest rate
real wage (measured in output)
Real vs Nominal Wage
An important relative price is the real wage:
W = nominal wage = price of labour, e.g.,
$15/hour
P = price level = price of g&s, e.g., $5/unit of
output
Real wage is the price of labour relative to the
price of output:
• W/P = $15/$5 per unit = 3 units of
output/hr.
Real and nominal
• For GDP, can real GDP ever go
up faster than nominal GDP??
Real-nominal
• If pdot>0, real GDP can’t grow
faster than nominal. BUT
•R
P
N
• 100
1
100
• 110
0.5
55
• This is DEFLATION
Neutrality of Money
• Monetary neutrality: changes in the
money supply do not affect real variables
in the long run. “Pure inflation”
• The real wage W/P remains unchanged, so
• quantity of labour supplied and
demanded don’t change so total
employment of labour does not change
• The same applies to employment of capital
and other resources.
• Since employment of all resources is
unchanged, total output is also unchanged
by the money supply.
Monetary Neutrality
An increase in the rate of
money growth increases
inflation but does not affect any
“real” variables (e.g. production,
employment, real wages, and
real interest rates.) Such LR
irrelevance of monetary
changes for “real” variables is
called monetary neutrality.
Principles of Macroeconomics:
Velocity and The
Quantity Equation
• “How many times per year is the
typical dollar bill used to pay for a
newly produced good or service?”
• The velocity of money refers to the
speed at which the typical dollar bill
travels around the economy from
wallet to wallet.
Principles of Macroeconomics:
Velocity and The
Quantity Equation
V = (P x Y) ÷ M
Where: V = Velocity
P = The average price level
Y = real output-GDP
M = the quantity of money
• Rewriting the equation gives
the quantity equation.
MxV=PxY
Principles of Macroeconomics:
Quantity Theory
•M x V = P x Y
• RHS is $ value of GDP purchased
• LHS is amount of money spent to buy
GDP
• RHS must equal LHS.
• Equation that must hold
Five Step Foundation to The
Quantity Theory of Money
The velocity of money is
relatively stable over time.
A proportionate change in the
nominal value of output is
related to changes in the
quantity of money by the B of C.
Because money is neutral,
money does not affect output.
Principles of Macroeconomics:
Five Step Foundation to The
Quantity Theory of Money
Changes in the money supply
which induce parallel changes
in the nominal value of output
are also reflected in changes in
the price level.
When the B of C increases the
money supply rapidly, the result
is a high rate of inflation.
Principles of Macroeconomics:
Quantity theory and
inflation
•MxV=PxY
• Assume V constant and Y (real
GDP) constant
• 2M x V = 2P x Y
• Inflations are based on ∆M---the
MS
• Printing money can’t make you
rich.
Nominal GDP, M2 and V
Hyperinflation &
Inflation Tax
• Hyperinflation is inflation that
exceeds 50 percent per month.
• Hyperinflation is caused by the
government printing too much
money to pay for their spending.
Principles of Macroeconomics:
Inflation Tax
• Deficit if G>T
• Usually G borrows to cover
deficit
• If no lenders have central bank
print money
• Gov’t pays for things (G) with
new money
• Gov’t controls central bank
Hyperinflation &
Inflation Tax
• When the government raises revenue
by printing money, it is said to levy an
inflation tax. An inflation tax is like a
tax on everyone who holds money.
• Tax on money because value of M
falls when lots more is supplied.
• The inflation ends when the
government institutes fiscal reforms
such as cuts in government spending.
Principles of Macroeconomics:
Hyperinflation
• Country end price
• Germany 1.02*1010
Monthly pdot
50
• August 1922-November 1923
• Hungary I
44
50
• March 1923 to Feb 1924
• Russia
1.24*105
• December 1921 to January 1924
57
Hungary again
• Country
end price
Monthly pdot
• Hungary II 3.81*1027
19,800
• July 1945 to July 1946
• Prices at worst doubled every 12
hours.
• Incentives-money is hot potato.
Spending fast is critical-work less.
4 Hyperinflations
Zimbabwe-2008
• Beginning of July 2008, official figures of
inflation rate at 355,000 percent. Some
independent estimates as high as
8,500,000 percent. On July 4, 2008, a
bottle of beer cost 100 billion Zimbabwean
dollars, but an hour later, the price had
gone up to $150 billion
• printing presses were running out of paper
to print the money. Contracted to China
• Finally-use of US$, Rand-No Z money.
Inflation causes ZWD to
fall---US$ to rise
Relationship Between
Money, Inflation and
Interest Rates
• Nominal Interest Rate =
Real Interest Rate + Inflation
Rate
• Over the long run, a change in
money growth should not affect
the Real Interest Rate thus, the
Nominal Interest Rate must
adjust one-for-one to changes in
the Inflation Rate.
Principles of Macroeconomics:
Relationship Between
Money, Inflation and
Interest Rates
• When the B of C increases the
rate of money growth, the result
is both a high inflation rate and
a higher nominal interest rate.
This is called the,
Fisher Effect
Principles of Macroeconomics:
Fisher Effect
• i = r + pdot
• Nominal = real + inflation
• “loose money”--- very
expansionary causes high i
• “tight money”--monetary policy
has lower i
Fisher effect
The Costs of Inflation
• At least six costs of inflation
are identified as:
1.
2.
3.
4.
5.
6.
Shoeleather costs
Menu Costs
More variability of relative prices
Tax liabilities
Confusion and inconvenience
Arbitrary redistribution of wealth
Principles of Macroeconomics:
The Costs of Inflation:
Shoeleather Costs
• Inflation reduces the real value of
money, so people have an incentive
to minimize their cash holdings.
Less cash requires people to make
frequent trips to the bank because
they keep their money in interest
bearing accounts.
• Extra trips to the bank takes time
away from productive activities.
Principles of Macroeconomics:
The Costs of Inflation:
Menu Costs
• During inflationary times, it is
necessary to update price lists
and other posted prices.
• This is a resource-consuming
process that takes away from
other productive activities.
Principles of Macroeconomics:
The Costs of Inflation:
Increased Variability of
Relative Prices
• During times of rising prices,
there will be a delay between
price increases. While these
prices are constant, other
prices will be rising. It then
becomes difficult to know exact
relative prices as prices change
irregularly. Px/Py
Principles of Macroeconomics:
The Costs of Inflation:
Unintended Changes in
Tax Liability
• With inflation, unadjusted
incomes are treated as real
gains. Consequently, with
progressive taxation, rising
nominal incomes are taxed
more heavily.
Principles of Macroeconomics:
The Costs of Inflation:
Confusion and
Inconvenience
• With rising prices, it is
necessary to constantly make
corrections in order to compare
real revenues, costs, and profits
over time. The time spent
making these adjustments
could have been spent
producing more goods and
services.
Principles of Macroeconomics:
The Costs of Inflation:
Arbitrary Redistribution
of Wealth
• With unanticipated or
incorrectly anticipated inflation,
wealth is redistributed between
net monetary debtors and
creditors. This may result in
wealth transfers that would not
otherwise be acceptable.
Principles of Macroeconomics:
The Inflation Fallacy
• Fallacy: “Inflation reduces
individuals’ incomes and causes
living standards to decline.”
• Fact: “One person’s inflated price is
another’s inflated income.” Unless
incomes are fixed in nominal terms,
the higher prices paid by consumers
are exactly offset by the higher
incomes received by sellers.
Principles of Macroeconomics:
CONCLUSION
• Prices rise when the govt prints
too much money. 10 Principles
• Money neutral in the long run,
affecting only nominal variables
but in the SR has important
effects on real variables like
output and employment.
Conclusion
• To explain inflation in the long run,
economists use the quantity theory
of money.
• The LR neutrality of money is the
idea that changes in the money
supply affect nominal variables, but
not real ones.
• Inflation tax is the loss in the real
value of people’s money when the
government causes inflation.
Conclusion
• The Fisher effect is the one-for-one
relation between changes in the
inflation rate and changes in the
nominal interest rate.
• The costs of inflation include menu
costs, shoeleather costs, confusion
and inconvenience, distortions in
relative prices and the allocation of
resources, tax distortions, and
arbitrary redistributions of wealth.