C HAPTER 14 M ONEY AND THE E CONOMY. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible.

CHAPTER 14

MONEY AND THE ECONOMY

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ADMINISTRATIVE DETAILS

The second exam will be next week, Thursday 19th.

The second exam will cover Chapters 10-14.

13-2


MONEY AND THE PRICE LEVELTHE CLASSICAL VIEW

Classical economists believed that changes in the money supply affect the price level in the economy, but not the level of output, i.e. monetary policy cannot be used to affect real GDP and employment.

This view is still held by many economists including Milton Friedman and others.

Based upon the Equation of Exchange which is an identity stating that the money supply times velocity* must be equal to the price level times Real GDP.

M x V ≡ P x Q

*The average number of times a dollar is spent to buy final goods and services in a year.


EQUATION OF EXCHANGE

M x V ≡ P x Q

where:•M represents Money Supply•V represents Velocity*•≡ means must be equal to •P represents Price•Q represents Real GDP

There is nothing profound about the Equation of Exchange because it is a simply mathematical identity like 2+2=4.


CALCULATING VELOCITY

In a large economy such as ours, it is impossible to simply count

how many times each dollar changes hands (velocity).

As an alternative:

M x V = P x Q Where:

1. GDP is equal to P x Q2. M x V = GDP3. V = GDP* / M*


EQUATION OF EXCHANGE - REVISITED

If:1. M x V = Total Spending2. P x Q = Total Sales Revenue of Business Firms

(GDP)

The Equation of Exchange simply says that the sum of everything bought (total spending) has to equal the sum of everything sold (total sales.

Total Spending ≡ Total Sales Revenue of Business Firms


SIMPLE QUANTITY THEORY OF MONEY

The theory that assumes that velocity (V) and Real GDP (Q) are constant in the short run and predicts that changes in the money supply (M) lead to strictly proportional changes in the price level (P).

M x V ≡ P x Q‾‾‾ ‾‾‾


REAL GDP

How much does Real GDP change from year to year?


VELOCITY


ASSUMPTIONS AND PREDICTIONS OF THE

SIMPLE QUANTITY THEORY OF MONEY

The simple quantity theory of money assumes that both V and Q are constant. (A bar over each indicates this in the exhibit.) The prediction is that changes in M lead to strictly proportional changes in P. Think of Q as “so many units of goods” and of P as the “average price paid per unit of these goods.”)


THE AD CURVE IN THE SIMPLE QUANTITY THEORY OF MONEY

M x V = Total Expenditures (TE)

TE = C + I + G + (X-M)

M x V = C + I + G + (X-M) = Aggregate Demand (AD)

Change in M and/or V will cause a change in AD


Aggregate Demand in the Simple Quantity Theory of Money

1. AD with V constant (a)

2. RGDP fixed in short run (b) -the level of Real GDP is assumed to be constant in the short run

3. M increases/decreases (c) causing AD to shift


VELOCITY AND REAL GDP VARIABLEIf we drop the assumptions that velocity (V ) and Real GDP (Q) are

constant, we have a more general theory of the factors that cause changes in the price level.

In this theory, changes in the price level depend on three variables:

1. Money supply (M)

2. Velocity (V)

3. Real GDP (Q)

M x V ≡ P x Q

If the equation of exchange holds, then

P ≡ M x V

Q

An increase in M and/or V and/or a decrease in Q will cause prices to rise.


MONETARISM IN A AD–AS FRAMEWORK IF:MONEY SUPPLY INCREASES


You combine the Equation of Exchange and the AD/AS model by noting that M*V =AD.

When there is an increase or decrease in M, AD correspondingly shifts to the right or left.


MONETARISM IN A AD–AS FRAMEWORK IF:MONEY SUPPLY DECREASES


A decrease in the money supply (M) will cause a decrease in AD putting the economy into a recessionary gap where prices go down and real GDP decreases temporarily.

Wages will fall and the AS will shift to the right moving the economy back to the LRAS.


MONETARISM IN A AD–AS FRAMEWORK IF:

VELOCITY INCREASES

An increase in velocity will cause AD to increase.

This will increase prices and real GDP in the short run.

In the long run, wages will increase leading to a leftward shift of the SRAS and returning the economy to the LRAS in the long run.



MONETARISM IN A AD–AS FRAMEWORK IF:VELOCITY DECREASES

A decrease in velocity will cause AD to increase.

This will decrease prices and real GDP in the short run.

In the long run, wages will decrease leading to a rightward shift of the SRAS and returning the economy to the LRAS in the long run.



MONETARIST VIEW OF THE ECONOMYMonetarists believe:1. The economy is self-regulating.Wages adjust

to the market forces of supply and demand captured statistically by the unemployment rate.

2. Changes in velocity and the money supply can change aggregate demand in the short run.

3. Changes in velocity and the money supply will change the price level and Real GDP in the short run but only the price level in the long run.


TWO ACTIVIST MONETARY POLICIES

One time increase in the money supply.

Continually increasing money supply.


INFLATIONINCREASE IN THE PRICE LEVEL I

One-Shot Inflation - A one-time increase in the price level caused by a one time increase in the money supply. An increase in the price level that does not continue.


ONE-SHOT INFLATION: DEMAND-SIDE, INDUCED

If monetary policy is a one-time increase in the money supply:

In the short run:

1.The aggregate demand curve shifts rightward from AD1 to AD2.2.As a result, the price level increases from P1 to P2.3.The economy moves from point 1 to point 2.

In the long run:

1.Wages will rise.2.SRAS will shift to the left.



ONE-SHOT INFLATION: SUPPLY-SIDEINDUCED I

Inflation can be caused by a shift in SRAS instead of an increase in the money supply.

1. The short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2.

2. As a result, the price level increases from P1 to P2; the economy moves from point 1 to point 2.

In the long run:

1. Because the Real GDP the economy produces (Q2) is less than Natural Real GDP, the unemployment rate that exists is greater than the natural unemployment rate.

2. Some economists argue that when this happens, wage rates will fall and the short-run aggregate supply curve will shift rightward from SRAS2 (back to SRAS1).

3. Long-run equilibrium is at point 1.


INFLATIONINCREASE IN THE PRICE LEVEL II

Continued Inflation - A continued increase in the price level.


CONTINUOUS INFLATION IBEGINS WITH SHIFT IN AD

1. The aggregate demand curve shifts rightward from AD1 to AD2.

2. The economy initially moves from point 1to point 2 and finally to point 3.

3. Continued increases in the price level are brought about through continued increases in aggregate demand.


CONTINUOUS INFLATION II

1. The short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2.

2. The economy initially moves from point 1 to point 2.

3. The economy will return to point 1 unless there is an increase in aggregate demand.

4. We see here that continued increases in the price level are brought about through continued increases in aggregate demand.


ECONOMIC VARIABLES AFFECTED BY A CHANGE IN THE MONEY SUPPLYWhen the FED engages in an activist monetary policy,

i.e. constantly changing the money supply it affects:

1. The supply of loans

2. Real GDP

3. The price level, and

4. The expected inflation rate

A Fed open market purchase increases reserves in the banking system and therefore increases the supply of loanable funds. As a result, the interest rate declines.


THE INTEREST RATE AND THE LOANABLE FUNDS MARKET

To supply bonds is to demand loanable funds.To demand bonds is to supply loanable funds


LIQUIDITY EFFECTThe change in the interest rate due to a change in the supply of loanable funds.

A Fed open market purchase increases reserves in the banking system and therefore increases the supply of loanable funds.

As a result, the interest rate declines.


INCOME EFFECT I

When real GDP increases, both the supply of and the demand for loanable funds increase.


INCOME EFFECT II

The overall effect on the interest rate is that, usually, the demand for loanable funds increases by more than the supply so that the interest rate rises.

The change in the interest rate due to a change in real GDP is called the income effect.

Permanent Income Hypothesis-Temporary vs. permanent


PRICE LEVEL EFFECTWhen the price level rises, the purchasing power of money falls.

People may therefore increase their demand for credit or loanable funds to borrow the funds necessary to buy a fixed bundle of goods.

This change in the interest rate due to a change in the price level is called the price-level effect.


EXPECTATIONS EFFECT I

Borrowers (demanders of loanable funds) will be willing to pay more interest for their loans because they expect to be paying back the loans with dollars that have less buying power than the dollars they are borrowing.

This will increase demand and reduce supply of loanable funds.


EXPECTATIONS EFFECT II

Lenders (the suppliers of loanable funds) require a higher interest rate to compensate them for the less valuable dollars with which the loan will be repaid. In effect, the supply of loanable funds curve shifts leftward. The change in the interest rate due to a change in the expected inflation rate.


WHAT HAPPENS TO THE INTEREST RATE AS THE

MONEY SUPPLY CHANGES?Point 1 in time: Fed says it will increase the growth rate of

the money supply.

Note that the FED doesn’t actually have to increase the money supply, it simply has to announce that it will and have people believe them.

1. Point 2 in time: If the expectations effect kicks in immediately, then . . .

2. Point 3 in time: Interest rates rise.

3. Point 4 in time: Liquidity effect kicks in.

4. Point 5 in time: As a result of what happened at point 4, the interest rate drops.

5. The interest rate is now lower than it was at point 3.


WHAT HAPPENS TO THE INTEREST RATE AS THEMONEY SUPPLY CHANGES?

1. A change in the money supply affects the economy in many ways.

2. Changing the supply of loanable funds directly, changing Real GDP and therefore changing the demand for and supply of loanable funds, changing the expected inflation rate, and so on.

3. The timing and magnitude of these effects determine the changes in the interest rate


HOW THE FED AFFECTS THE INTEREST RATES

Liquidity Effect →

Income Effect →

Price Level Effect →

Expectations Effect →

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MONETARY POLICY

1. The Federal Reserve-Institutional Details.2. Money Supply Process – How the FED

controls the money supply



Fed Monetary Tools and Their Effects on the Money Supply


Dollars Saved or Invested

InterestRate

Investment

Savings

AllOtherGoods

Real GDPGood X

PriceLevel LRAS

Natural GDP

SRAS

ADInstitutional PPF Physical PPF

Be able to show how a change in the money supply affects the price level (inflation), real GDP, unemployment, and interest rates in the short and long run.


HOW THE FED AFFECTS THE INTEREST RATES

Liquidity Effect →

Income Effect →

Price Level Effect →

Expectations Effect →

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C HAPTER 14 M ONEY AND THE E CONOMY. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible.

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