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Chapter 17 Notes

by: Carter Cox

Chapter 17 Notes EC 111

Carter Cox

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Economics cover all of chapter
Principles of Macroeconomics
Class Notes
Economics, Macroeconomics
25 ?




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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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