USC ECON 205 - The Monetary System

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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 LectureQuantity Theory of Money- Explains a key principle ofeconomics- Quantity Theory of Money-prices rise when thegovernment prints toomuch money- Good explanation of long-run behaviors of inflationValue of Money- P= price levelo Price of a basket ofgoods, measured interms of money- 1/P is the value of $1,measured in goodso i.e. basket contains 1 candy bar if P=$2, value of $1 is ½ a candy bar if P=$3, value of $1 is 1/3 a candy bar- inflation increases price and decreases the value of moneyThe 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 moneyMoney 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 buygoods and serviceso 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 PA 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 ito Result: an increased demand for goodsReal vs. Nominal Variables- Nominal variables- measured in monetary units- Real variables- measured in physical unitso 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) anothero 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 outputo W / P = ($15/hour) / ($5/units of output) = 3 units of output per hourThe Classical Dichotomy- Classical Dichotomy- theoretical separation of nominal and real variables- Monetary developments affect nominal variables, but not real variablesNeutrality 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 sameo Quantity of labor demanded stays the sameo 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 variablesVelocity 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 supplyo V = velocity- Velocity formula: V = (P x Y) / M- I.e. one good: pizzao Y = real GDP = 3000 pizzaso P = price level = price of pizza = $10o P x Y = nominal GDP = value of pizzas = $30,000o M = money supply = $10,000o V = (30,000) / (10,000) = 3 Average dollar was used in 3 transactions- Velocity is fairly stable over the long runo Can be accounted for as a constantThe Quantity Equation- Multiply both sides of the velocity formula by M- M x V = P x Y =Quantity EquationQuantity Theory in 5 Steps1) V is stable2) A change in M causes nominal GDP to change by the same percentage3) A change in M doesn’t affect Y: money is neutral, Y is determined by technology and resources4) So, P changes by same percentage as P x Y and M5) Rapid money supply causes rapid inflationHyperinflation- Hyperinflation- inflation exceeding 50% per month- Excessive growth in money supply always leads to

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