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Chapter 17 - Monetary Growth and Inflation

by: Erin Payne

Chapter 17 - Monetary Growth and Inflation Econ 110

Marketplace > Kansas State University > Economcs > Econ 110 > Chapter 17 Monetary Growth and Inflation
Erin Payne

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About this Document

These notes cover the lectures of Dr. Mohaned Al-Hamdi for the weeks 4/20/16 - 4/27/16 (Week 13).
principles of Macroeconomics
Dr. Al-Hamdi
Class Notes
Macroeconomics, Econ, 110, Chapter, 17, Monetary, growth, inflation
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This 6 page Class Notes was uploaded by Erin Payne on Friday April 29, 2016. The Class Notes belongs to Econ 110 at Kansas State University taught by Dr. Al-Hamdi in Spring 2016. Since its upload, it has received 12 views. For similar materials see principles of Macroeconomics in Economcs at Kansas State University.

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Date Created: 04/29/16
  Week 13  April 20th ­ April 27th  Spring 2016      Chapter 17 Notes  Money Growth and Inflation    ● Inflation  ○ Increase in the overall level of prices.  ● Deflation  ○ Decrease in the overall rate of prices.  ● Hyperinflation  ○ Extraordinarily high rate of inflation.  ● Classical Theory of Money  ○ Quantity theory of money.  ○ Explains the long­run determinants of price levels.  ○ Explains the inflation rate.  ● Value of Money = 1/P where P = price level.  ● Inflation  ○ Economy­wide phenomenon.  ○ Concerns the value of the economy’s medium of exchange.  ● Inflation: Rise in the Price Level  ○ Lower value of money.  ○ Each dollar buys a smaller quantity of goods and services.  ● Quantity demanded of money is how much money out of their wealth that people  want to keep with themselves in liquid form.  ● Money Demand  ○ Reflects how much money wealth people want to hold in liquid form.  ○ Depends on:  ■ Credit cards.  ■ Availability of ATMs.  ■ Interest rate.  ■ Average level of prices in economy. (Greatest influencer because it  determines for most how much liquid money you keep in your  pocket.)  ○ Demand curve ­ downward slope.  ● In Money Market: P↑ = Qd of Money↑  ○ ∴Because value of money = 1/P. If value of money↓, the Qd of money↑.  ● Money Supply  ○ Determined by the Fed and the banking system.  ○ Supply curve is vertical.  Notes Key:Bolded texts = most important facts stressed by professor.       ∴ symbol = “Therefore” or “In other words”.       “ ” = Specific definition or word choice provided  y instructor.   Week 13  April 20th ­ April 27th  Spring 2016      ● In the Long Run  ○ Overall level of prices adjust.  ■ To the level at which the demand for money equals the supply.  ● Economy is in Equilibrium  ○ If the Fed doubles the supply of money.  ■ Prints bills.  ■ Drops them on market.  ○ Or the Fed: open­market purchases.  ○ New equilibrium.  ■ Supply curve shifts right (an act of the central bank).  ■ Value of money decreases.  ■ Price level increases.  ● Quantity Theory of Money  ○ The quantity of money available in the economy determines (the value of  money) the price level.  ○ Growth rate in quantity of money available determines the inflation rate.  ● Adjustment Process  ○ Excess supply of money.  ○ Increase in demand of goods and services.  ○ Prices of goods and services increases.  ○ Increase in price level.  ○ Increase in the quantity of money demanded.  ○ New equilibrium.  ● Nominal Variables  ○ Variables measured in money units.  ○ Price = $100 ⇒ Nominal variables.  ■ Ex. Dollar prices.  ● Real Variables  ○ Variables measure in physical units.  ○ Quantity = 1 TV ⇒ Real variable.  ■ Ex. Relative prices, real wages, real interest rate.  ● Classical Dichotomy  ○ Theoretical separation of nominal and real variables.  Price of Item 1 ● Relative Price =  Price of Item 2 ● Developments in the Monetary System  ○ Influence nominal variables.  ○ Irrelevant for explaining real variables.  Notes Key:Bolded texts = most important facts stressed by professor.       ∴ symbol = “Therefore” or “In other words”.       “ ” = Specific definition or word choice provided by instructor.   Week 13  April 20th ­ April 27th  Spring 2016      ● Monetary Neutrality  ○ Changes in money supply don’t affect real variables.  ○ Not completely realistic in short­run.  ○ Correct in the long­run.  ○ ∴“Money affects nominal variables but not real variables.”  ● Quantity Equation of Money: M * V = P * Y  ○ Quantity of money (M).  ○ Velocity of money (V).  ○  P is the price level (P).  ○ Real GDP (Y).  ■ Dollar value of economy’s output of goods and services = P * Y.  ○ Shows: an increase in the quantity of money.  ■ Must be reflected in:  ● Price level must rise.  ● Quantity of output must rise.  ● Velocity of money must fall.  ● Velocity of Money (V)  ○ Rate at which money changes hands.  ○ V = (P * Y) / M.  ■ P = Price level (GDP Deflator).  ■ Y = Real GDP.  ■ M = Quantity of Money.  ● %ΔM +%ΔV = %ΔP +%ΔY   ○ Assumption that V is constant.  ○ %ΔM = Money growth rate.  ○ %ΔP = Inflation rate.  ○ %ΔY = Real GDP growth rate.  ○ ∴Inflation rate = Money growth rate ­ Real GDP growth rate.  ● ∴“Inflation happens when the money growth rate is higher than the real GDP growth  rate.”  ● Quantity Theory of Money  ○ Velocity of Money  ■ Relatively stable over time.  ○ Changes in quantity of money, M  ■ Proportionate changes in nominal value of output (P * Y).  ○ Economy’s output of goods & services, Y  ■ Primarily determined by factor supplies.  Notes Key Bolded texts = most important facts stressed by professor.       ∴ symbol = “Therefore” or “In other words”.       “ ” = Specific definition or word choice provided  y instructor.   Week 13  April 20th ­ April 27th  Spring 2016      ■ And available production technology.  ■ Money does not affect output.  ○ Changes in money supply, M  ■ Induces proportional changes in the nominal value of output (P * Y).  ● Reflected in changes in the price level (P).  ○ When the central bank increases the money supply rapidly.  ■ High rate of inflation.  ● The Inflation Tax  ○ Revenue the government raises by creating (printing) money.  ○ Tax on ​ everyone​  who holds money.  ■ When the government prints money.  ■ The price level rises.  ■ And the dollars in your wallet are less valuable.  ○ “Same effect as if they taxed you and physically took your money.”  ● Principle of monetary neutrality.  ○ An increase in the rate of money growth.  ○ Raises the rate of inflation.  ○ But does not affect any real variable.  ● Real interest rate = Nominal interest rate ­ Inflation rate.  ● Nominal interest rate = Real interest rate + Inflation rate.  ○ Remember: Nominal interest rate is a payment on a loan, and it is typically  set when the loan is first made.  ● Fisher Effect  ○ One­of­one adjustment of nominal interest rate to inflation rate.  ○ When the Fed increases the rate of money growth.  ○ Long­run result.  ■ Higher inflation rate.  ■ Higher nominal interest rate.  ● Inflation Fallacy  ○ “Inflation robs people of the purchasing power of his hard­earned dollars.”  ○ ∴“As prices go up, so do the incomes of the people. Because of this, this is not  the real cost of inflation.”  ● When prices rise  ○ Buyers pay more.  ○ Sellers get more.  ● Inflation does not in itself reduce people’s real purchasing power.  ● Shoeleather Costs  Notes Key:Bolded texts = most important facts stressed by professor.       ∴ symbol = “Therefore” or “In other words”.       “ ” = Specific definition or word choice provided by instructor.   Week 13  April 20th ­ April 27th  Spring 2016      ○ Resources wasted when inflation encourages people to reduce their money  holdings.  ○ Can be substantial.  ○ “A metaphor for the loss of resources necessary to protect your money.”  ● Menu Costs  ○ Costs of changing prices.  ○ Inflation ­ increases menu costs that firms must bear.  ● Market Economies  ○ Relative prices allocate scarce resources.  ○ Consumers compare quality and prices of various goods and services.  ■ Determine allocation of scarce factors of production.  ○ Inflation distorts relative prices.  ■ Consumer decisions are distorted.  ■ Markets are less able to allocate resources to their best use.  ● Taxes Distort Incentives  ○ Many taxes: more problematic in the presence of inflation.  ● Tax Treatment of Capital Gains  ○ Capital gains are profits.  ■ Sell an asset for more than its purchase price.  ○ Inflation discourages saving.  ■ Exaggerates the size of capital gains.  ■ Increases the tax burden.  ● Tax Treatment of Interest Income  ○ Nominal interest earned on savings.  ■ Treated as income.  ■ Even though part of the nominal interest rate compensates for inflation.  ● Higher Inflation  ○ Tends to discourage people from saving.  ● Confusion and Inconvenience  ○ Money  ■ Yardstick with which we measure economic transactions.  ○ The Fed’s Job  ■ Ensure the reliability of money.  ○ When the Fed increases money supply  ■ Creates inflation.  ■ Erodes the real value of the unit of account.  ● Redistribution of Wealth  Notes Key:Bolded texts = most important facts stressed by professor.       ∴ symbol = “Therefore” or “In other words”.       “ ” = Specific definition or word choice provided b  instructor.   Week 13  April 20th ­ April 27th  Spring 2016      ○ Unexpected Inflation  ■ Redistributes wealth among the population.  ● Not by merit.  ● Not by need.  ■ Redistribute wealth among debtors and creditors.  ○ Inflation: volatile and uncertain.  ■ When the average rate of inflation is high.  ● Deflation May Be Worse  ○ Small and predictable amount of deflation.  ■ May be desirable.  ○ The Friedman rule: moderate deflation will.  ■ Lower the nominal interest rate.  ■ Reduce the cost of holding money.  ■ Shoeleather costs of holding money ­ minimized by a nominal interest rate  close to zero.  ● Deflation equal to the real interest rate.  ● Costs of Deflation  ○ Menu costs.  ○ Relative­price variability.  ○ If not steady and predictable.  ■ Redistribution of wealth toward creditors and away from debtors.  ○ Arises because of broader macroeconomic difficulties.  ■ Symptom of deeper economic problems.  Notes Key: Bolded texts = most important facts stressed by professor.       ∴ symbol = “Therefore” or “In other words”.       “ ” = Specific definition or word choice provided by  nstructor.


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