Chapter 17 Notes
Chapter 17 Notes EC 111
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This 5 page Class Notes was uploaded by Carter Cox on Tuesday April 5, 2016. The Class Notes belongs to EC 111 at University of Alabama - Tuscaloosa taught by Zirlott in Spring 2015. Since its upload, it has received 41 views. For similar materials see Principles of Macroeconomics in Economcs at University of Alabama - Tuscaloosa.
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Date Created: 04/05/16
Chapter 17 Macroeconomics Introduction Quantity theory of money o This chapter introduces this theory to explain one of the ten principles of economics o Prices rise when the government prints too much money Most economists believe the quantity theory is a good explanation of the long run behavior of inflation The Value of Money P is equal to Price Level (CPI or GDP Deflator) o P is the price of a basket of goods, measured in money 1/P is the value of $1 measured in goods o Example: basket contains one candy bar P= $2, value of $1 is ½ candy bars Inflation drives up prices and drives down the value of money The Quantity Theory of Money developed by 18 century philosopher David Hume Advocated more recently by Laureate Milton Friedman Asserts that the quantity of money determines the value of money 2 approaches o Supply demand diagram o Equation Money Supply MS is determined by Federal Reserve, the banking system, and consumers in the real world We assume the FED precisely controls MS and sets it at some fixed amount Money Demand – how much cash you hold Refers to how much wealth people want to hold in liquid for o Most liquid form is cash Depends on P o An increase in price level reduces the value of money, so more money is required to buy goods and services The quantity of money demanded is negatively related to the value of money and positively related to P, other things equal If prices levels rise you have to pay more Money Supply Diagram FED sets MS at some fixed value o 1 – perfectly inelastic If Fed precisely fix the MS then it is perfectly inelastic As the price level falls the value of money rises Demand for money is like the traditional demand curve, which is downward sloping P adjusts to equate quantity of money demanded with money supply Real VS Nominal Variables Nominal Variables measured in monetary units o Examples: Nominal GDP, nominal interest rate (rate of return measured in $), nominal wage ($ per hour worked), minimum wage Real Variables – measured in physical units o Examples: Real GDP, real interest rate (measured in output), real wage (measured in output) What can you buy with wage Relative Price o Price of one good relative to (divided by) another Example Price of a CD is $15 Price of a pizza $10 CD in terms of Pizza 15/10= 1.5 pizzas per cd o Measured in physical units, so they are real variables Real VS Nominal Wage W= nominal wage= price of labor P= price level= price of goods and services Real wage is the price of labor relative to the price of output o W/P The Classic Dichotomy Classical dichotomy nominal and real don’t interact o Theoretical separation of nominal and real variables Hume and the classical economists suggested that monetary developments affect nominal variables but not real If the central bank double the MS, Hume and classical thinkers contend o All nominal variables including prices will double o All real variables including relative prices will remain unchanged The Neutrality of Money Monetary Neutrality o The proposition that changes in the money supply do not affect real variables Doubling the MS causes all nominal prices to double Most economists believe the classical dichotomy and neutrality of money describe the economy in the long run The Velocity of Money the rate at which money changes hands V= (P x Y)/ M (P x Y) is nominal GDP M is the money supply V is velocity The Quantity Equation M x V = P x Y o Represents entire economy The quantity theory in 5 steps V is stable So, change in M causes nominal GDP to change by the same percentage o M goes up 10% then GDP goes up 10% A change in M does not affect Y o Money is neutral when it comes to real output o Y is determined by technology and resources So, P changes by the same percentage as P x Y and M Rapid money supply growth cause rapid inflation Hyperinflation Defined as inflation exceeding 50% per month Prices rise when the government massively prints too much money Excessive growth in the money supply always causes hyperinflation The Inflation Tax when tax revenue is inadequate and ability to borrow is limited, government may print money to pay for its spending the revenue from printing money is called inflation tax The Fisher Effect Nominal interest rate = inflation rate + real interest rate In long run money is neutral, so a change in the money growth rate affects the inflation rate but not the real interest rate The nominal interest rate adjusts one for one with changes in the inflation rate Costs of Inflation Inflation fallacy most people think inflation erodes real incomes or their purchasing power Inflation generally increases in price of the things people buy and the thing they sell, so income rise Long run, real incomes are determined by real variables, such as human capital, physical capital, technology, and natural resources Nominal income = real income + inflation rate Costs of Inflation Shoe leather Costs the resources wasted when inflation encourages people to reduce their money holdings how much cash you hold o Includes the time and transactions costs of more frequent bank withdrawals Menu Costs o Costs of changing prices o Printing new menus, mailing new catalogs o Higher inflation causes more frequent price changes which leads to higher menu costs Misallocation of Resources from Relative price variability Firms don’t all raise prices at the same time, so relative prices can vary.. Which distorts the allocation of resources Confusion and Convenience Inflation changes the yardstick we use to measure transactions Tax Distortions o Inflation makes nominal income grow faster than real income o Taxes are based on nominal income and some are not adjusted for inflation o So inflation causes people to pay more taxes even when their real incomes don’t increase A Special Cost of Unexpected Inflation Arbitrary redistributions of wealth o Higher than expected inflation transfers purchasing power from creditors to debtors; Debtors get to repay their debt with dollars that aren’t worth as much o Lower than expected inflation transfers purchasing power from debtors to creditors o High inflation is more variable and less predictable than low inflation o These arbitrary redistributions are frequent when inflation is high The Cost of Inflation All these costs are quite high for economies experiencing hyperinflation For economies with low inflation (US) (< 10% peryear), these costs are probably much smaller though their exact size is open to debate.
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