Principles of Macroeconomics
Principles of Macroeconomics ECON 1010
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Burgess Macroeconomics 1010 Topic 11 Money Growth and In ation 1Introduction 2The Classical Theory of In ation 21 The Level of Prices and the Value of Money 22 Money Supply Money Demand and Monetary Equilibrium 23 The Effects of a Monetary Injection 24 The Classical Dichotomy and Monetary Neutrality 25 Velocity and the Quantity Equation 26 The Equilibrium Price Level In ation Rate and the Quantity Theory of Money 27 The In ation Tax 28 The Fisher Effect Burgess Macroeconomics 1010 3The Costs of In ation A Fall in Purchasing Power The In ation Fallacy Shoeleather Costs Menu Costs RelativePrice Variability and the Misallocation of Resources In ation Induced Tax Distortions Confusion and Inconvenience A Special Cost of Unexpected In ation Arbitary Redistribution of Wealth 4 Summary Burgess Macroeconomics 1010 3 2 The Classical Theory of In ation In ation is an increase in the overall level of prices 21 The Level of Prices and the Value of Money oOver the past sixty years prices have risen on average about 5 percent per year oDe ation meaning decreasing average prices occurred in the U S in the nineteenth century oHyperin ation refers to high rates of in ation such as Germany experienced in the 19205 oln the 19705 prices rose by 7 percent per year oDuring the 19905 prices rose at an average rate of 2 percent per year Burgess Macroeconomics 1010 4 The quantity theory of money is used to explain the longrun determinants of the price level and the in ation rate olnflation is an economyWide phenomenon that concerns the value of the economy s medium of exchange oWhen the overall price level rises the value of money falls 22 Money Supply Money Demand and Monetary Equilibrium The money supply is a policy variable that is controlled by the Fed Through instruments such as openmarket operations the Fed directly controls the quantity of money supplied Money demand has several determinants including interest rates and the average level of prices in the economy Burgess Macroeconomics 1010 5 People hold money because it is the medium of exchange The amount of money people choose to hold depends on the prices of 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 23 The Effects of Monetary Injection How the price level is determined and Why it might change over time is called the quantity theory of money oThe quantity of money available in the economy determines the value of money oThe primary cause of in ation is the growth in the quantity of money Burgess Macroeconomics 1010 24 The Classical Dichotomy and Monetary Neutrality oNominal variables are variables measured in monetary units oReal variables are variables measured in physical units According to Hume and others real economic variables do not change with changes in the money supply According to the classical dichotomy different forces in uence 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 Burgess Macroeconomics 1010 25 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 VPXYM Where V velocity P the price level Y the quantity of output M the quantity of money Rewriting the equation gives the quantity equation M X V P X Y The quantity equation relates the quantity of money M to the nominal value of output P X Y Burgess Macroeconomics 1010 The quantity equation shows that an increase in the quantity of money in an economy must be re ected in one of three other variables othe price level must rise othe quantity of output must rise or othe velocity of money must fall 26 The Equilibrium Price Level In ation Rate and the Quantity Theory of Money oThe velocity of money is relatively stable over time oWhen the Fed changes the quantity of money it causes proportionate changes in the nominal value of output P X Y oBecause money is neutral money does not affect output oWhen the Fed alters the money supply and induces parallel changes in the nominal value of output these changes are also re ected in changes in the price level oWhen the Fed increases the money supply rapidly the result is a high rate of in ation Burgess Macroeconomics 1010 9 oHyperin ation is in ation that exceeds 50 percent per month o Hyperin ation occurs in some countries because the government prints too much money to pay for its spending 27 The In ation Tax oWhen the government raises revenue by printing money it is said to levy an in ation tax oAn in ation tax is like a tax on everyone who holds money o The in ation ends when the government institutes fiscal reforms such as cuts in government spending 28 The Fisher Effect oAccording t0 the Fisher effect when the rate of in ation rises the nominal interest rate rises by the same amount o The real interest rate stays the same Burgess Macroeconomics 1010 10 3The Costs of In ation A Fall in Purchasing Power The In ation Fallacy In ation does not in itself reduce people s real purchasing power 32 Shoeleather Costs Shoeleather costs are the resources wasted when in ation encourages people to reduce their money holdings In ation reduces the real value of money so people have an incentive to minimize their cash holdings Less cash requires more frequent trips to the bank to withdraw money from interestbearing accounts The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand Burgess Macroeconomics 1010 11 Also extra trips to the bank take time away from productive activities 33 Menu Costs Menu costs are the costs of adjusting prices During in ationary times it is necessary to update price lists and other posted prices This is a resourceconsuming process that takes away from other productive activities 34 RelativePrice Variability In ation distorts relative prices Consumer decisions are distorted and markets are less able to allocate resources to their best use Burgess Macroeconomics 1010 12 35 In ationInduced Tax Distortion In ation exaggerates the size of capital gains and increases the tax burden on this type of income With progressive taxation capital gains are taxed more heavily The income tax treats the nominal interest earned on savings as income even though part of the nominal interest rate merely compensates for in ation The aftertax real interest rate falls making saving less attractive Burgess Macroeconomics 1010 13 36 Confusion and Inconvenience When the Fed increases the money supply and creates in ation it erodes the real value of the unit of account In ation causes dollars at different times to have different real values Therefore with rising prices it is more difficult to compare real revenues costs and profits over time 37 Arbitrary Redistribution of Wealth Unexpected in ation redistributes wealth among the population in a way that has nothing to do with either merit or need These redistributions occur because many loans in the economy are specified in terms of the unit of account money Burgess Macroeconomics 1010 14 4 Summary oThe overall level of prices in an economy adjusts to bring money supply and money demand into balance oWhen the central bank increases the supply of money it causes the price level to rise oPersistent growth in the quantity of money supplied leads to continuing in ation oThe principle of money neutrality asserts that changes in the quantity of money in uence nominal variables but not real variables oA government can pay for its spending simply by printing more money o This can result in an in ation tax and hyperin ation Burgess Macroeconomics 1010 15 oAccording t0 the Fisher effect when the in ation rate rises the nominal interest rate rises by the same amount and the real interest rate stays the same oMany people think that in ation makes them poorer because it raises the cost of what they buy oThis view is a fallacy because in ation also raises nominal incomes oEconomists have identified six costs of in ation o Shoeleather costs oMenu costs olncreased variability of relative prices oUnintended taX liability changes oConfusion and inconvenience oArbitrary redistributions of wealth Burgess Macroeconomics 1010 1 Topic 8 Saving Investment and the Financial System 1 Introduction 2 The Financial System and Financial Institutions in the US Economy The Bond Market The Stock Market Banks Mutual Funds Other Financial Institutions 3 Saving and Investment in National Income Accounts Some Important Identities Saving and Investment 4 The Market for Loanable Funds Supply and Demand for Loanable Funds Policy 1 Taxes and Saving Policy 2 Taxes and Investment Policy 3 Government Budget Deficits and Surpluses 5 Summary Burgess Macroeconomics 1010 2 2The Financial System and Financial Institutions in the US Economy The financial system consists of institutions that help to match one person s saving with another person s investment It moves the economy s scarce resources from savers to borrowers The financial system is made up of financial institutions that coordinate the actions of savers and borrowers Financial institutions can be grouped into two different categories financial markets and financial intermediaries Financial Markets are the institutions through which savers can directly provide funds to borrowers 9 Stock Market oBOIld Market Financial Intermediaries are financial institutions through which savers can indirectly provide funds to borrowers oBanks oMutual Funds Burgess Macroeconomics 1010 3 21 Financial Markets The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond Characteristics of a Bond oTerm The length of time until the bond matures oCredit Risk The probability that the borrower will fail to pay some of the interest or principal oTaX Treatment The way in which the tax laws treat the interest on the bond Municipal bonds are federal tax exempt Burgess Macroeconomics 1010 4 22 Financial Markets The Stock Market Stock represents ownership in a firm and is therefore a claim to the profits that the firm makes The sale of stock to raise money is called equity financing Compared to bonds stocks offer both higher risk and potentially higher returns The most important stock exchanges in the United States are the New York Stock Exchange the American Stock Exchange and NASDAQ Most newspaper stock tables provide the following information oPrice of a share oVolume number of shares sold oDiVidend profits paid to stockholders oPriceearnings ratio Burgess Macroeconomics 1010 5 23 Financial Intermediaries Banks Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans Banks help create a medium of exchange by allowing people to write checks against their deposits A medium of exchanges is an item that people can easily use to engage in transactions This facilitates the purchases of goods and services Financial Intermediaries Mutual Funds A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a selection or portfolio of various types of stocks bonds or both They allow people with small amounts of money to easily diversify 25 Other Financial Institutions Credit unions Pension funds Insurance companies Loan sharks Burgess Macroeconomics 1010 6 3 Saving and Investment in the National Income Accounts GDP is both total income in an economy and total expenditure on the economy s output of goods and services Y C I G NX 31 Some Important Identities Assume a closed economy ie one that does not engage in international trade YCIG Now subtract C and G from both sides of the equation Y C GI Burgess Macroeconomics 1010 7 Y C GI The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving or just saving S Substituting S for Y CG the equation can be written as Burgess Macroeconomics 1010 8 32 Saving and Investment National saving for the economy as a Whole saving must be equal to investment SI Private saving is the amount of income that households have left after paying their taxes and paying for their consumption Private saving Y T C Public saving is the amount of tax revenue that the government has left after paying for its spending Public saving T G Budget Surplus and Deficit If TgtG the government runs a budget surplus because it receives more money than it spends If GgtT the government runs a budget deficit because it spends more money than it receives in tax revenue Burgess Macroeconomics 1010 9 4 The Market for Loanable Funds Financial markets coordinate the economy s saving and investment in the market for loanable funds Loanable funds refers to all income that people have chosen to save and lend out rather than use for their own consumption 41 Supply and Demand for Loanable Funds The supply of loanable funds comes from people who have extra income they want to save and lend out The demand for loanable funds comes from households and firms that Wish to borrow to make investments The interest rate is the price of the loan It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving The interest rate in the market for loanable funds is the real interest rate Burgess Macroeconomics 1010 10 Financial markets work much like other markets in the economy The equilibrium of the supply and demand for loanable funds determines the real interest rate Government policies may affect the incentive for saving and investment 42 Policy 1 Taxes and Saving Taxes on interest income substantially reduce the future payoff from current saving and as a result reduce the incentive to save A taX decrease increases the incentive for households to save at any given interest rate Increases the supply of loanable funds Shifts the supply curve to the right The equilibrium interest rate decreases If a change in taX law encourages greater saving the result will be lower interest rates and greater investment Burgess Macroeconomics 1010 11 43 Policy 2 Taxes and Investment An investment tax credit increases the incentive to borrow Increases the demand for loanable funds Shifts the demand curve to the right The equilibrium interest rate increases The quantity demanded for loanable funds increases If a change in tax laws encourages greater investment the result will be higher interest rates and greater saving Burgess Macroeconomics 1010 12 44 Government Budget Deficits and Surpluses When the government spends more than it receives in tax revenues the short fall is called the budget deficit The accumulation of past budget deficits is called the government debt Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms This fall in investment is referred to as crowding out The deficit borrowing crowds out private borrowers who are trying to finance investments A budget deficit decreases the supply of loanable funds oShlftS the supply curve to the left olncreases the equilibrium interest rate oReduces the equilibrium quantity of loanable funds When government reduces national saving by running a deficit the interest rate rises and investment falls Burgess Macroeconomics 1010 13 A budget surplus increases the supply of loanable funds reduces the interest rate and stimulates investment Burgess Macroeconomics 1010 14 5 Summary oThe US financial system is made up of financial institutions such as the bond market the stock market banks and mutual funds oAll these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow oNational income accounting identities reveal some important relationships among macroeconomic variables oln particular in a closed economy national saving must equal investment oFinancial institutions attempt to match one person s saving with another person s investment oThe interest rate is determined by the supply and demand for loanable funds Burgess Macroeconomics 1010 15 oThe supply of loanable funds comes from households who want to save some of their income oThe demand for loanable funds comes from households and firms who want to borrow for investment oNational saving equals private saving plus public saving oA government budget deficit represents negative public saving and therefore reduces national saving and the supply of loanable funds oWhen a government budget deficit crowds out investment it reduces the growth of productivity and GDP
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