ECON 205 1st Edition Lecture 15 Outline of Last Lecture How does money supple affect inflation and nominal interest rates Quantity theory of money Does the money supply affect real variables like real GDP or the real interest rate How is inflation like a tax Outline of Current Lecture Quantity Theory of Money Value of Money The Quantity Theory of Money Money Demand MD Current Lecture Quantity Theory of Money Explains a key principle of economics Quantity Theory of Moneyprices rise when the government prints too much money Good explanation of longrun behaviors of inflation Value of Money P price level o Price of a basket of goods measured in terms of money 1 P is the value of 1 measured in goods o i e basket contains 1 candy bar if P 2 value of 1 is a candy bar if P 3 value of 1 is 1 3 a candy bar inflation increases price and decreases the value of money The Quantity Theory of Money developed by 18th century philosopher David Hume inflation is always and everywhere a monetary phenomenon Asserts that the quantity of money determines the value of money Money Demand MD Refers to how much wealth people want to hold in liquid form Depends on P an increase in P decreases value of money so more money needed to buy goods and services o Therefore quantity of money is negatively related to the value of money and positively related to P If you ignore real income interest and the availability of ATMS The graph shows the inverse relationship Supply of money is inelastic MD1 decreases the value of money while it increases the quantity demanded Fed sets MS at a fixed value regardless of P A Brief Look at the Adjustment Process At initial P an increase in MS creates an excess money supply People get rid of their excess money by spending it on goods and services of by loaning it to others who spend it o Result an increased demand for goods Real vs Nominal Variables Nominal variables measured in monetary units Real variables measured in physical units o i e nominal wage is money per hour and real wage is output per hour Relative price price of on good relative to divided by another o i e relative price of CDs in terms of pizza price of CD price of pizza 15 10 1 5 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 15 hour 5 units of output 3 units of output per hour The Classical Dichotomy Classical Dichotomy theoretical separation of nominal and real variables Monetary developments affect nominal variables but not real variables Neutrality of Money Monetary Neutrality the proposition that changes in the money supply do not affect real variables Real wage stays the same so o Quantity of labor supply stays the same o Quantity of labor demanded stays the same o Therefore total employment stays the same Since employment of all resources is unchanged total output is also unchanged by MS Most economists believe the classical dichotomy and neutrality of money describe the economy in the long run Monetary changes can have important short run effects on real variables Velocity of Money Velocity of money rate at which money changes hands Notion o P x Y nominal GDP price level x real GDP o M money supply o V velocity Velocity formula V P x Y M I e one good pizza o Y real GDP 3000 pizzas o P price level price of pizza 10 o P x Y nominal GDP value of pizzas 30 000 o M money supply 10 000 o V 30 000 10 000 3 Average dollar was used in 3 transactions Velocity is fairly stable over the long run o Can be accounted for as a constant The Quantity Equation Multiply both sides of the velocity formula by M M x V P x Y Quantity Equation Quantity Theory in 5 Steps 1 V is stable 2 A change in M causes nominal GDP to change by the same percentage 3 A change in M doesn t affect Y money is neutral Y is determined by technology and resources 4 So P changes by same percentage as P x Y and M 5 Rapid money supply causes rapid inflation Hyperinflation Hyperinflation inflation exceeding 50 per month Excessive growth in money supply always leads to hyperinflation