CHAPTER 8QuestionsSlide 3InflationFigure 8.1 - Post-World War II Inflation in the United States, 1951-2000The Flexible-Price ModelMoneyThe Usefulness of MoneyFigure 8.2 - Coincidence of WantsSlide 10The Demand for MoneyFigure 8.3 - Reasons for and Opportunity Cost of Holding MoneyThe Quantity Theory of MoneySlide 14Figure 8.4 - The Velocity of MoneyDetermining the Price LevelSlide 17Slide 18Slide 19The Money StockSlide 21Figure 8.5 - Open Market OperationsSlide 23Slide 24Table 8.1 - Measures of the Money StockSlide 26Slide 27Slide 28Slide 29Figure 8.6 - Money Growth and Inflation Are Not Always ParallelMoney DemandSlide 32Figure 8.7 - Money Demand and the Inflation RateSlide 34Slide 35Money, Prices, and InflationFigure 8.8 - Effects of a Rise in Money GrowthThe Costs of InflationSlide 39HyperinflationFigure 8.9 - The Inflation TaxSlide 42Chapter SummarySlide 44Slide 45Slide 46Slide 47Slide 48Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-1CHAPTER 8Money, Prices, and InflationCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-2Questions•What do economists mean by “money”?•Why is money useful?•What do economists mean when they say that money is a unit of account?•What determines the price level and the inflation rate?Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-3Questions•Why would a government ever generate “hyperinflation”?•What determines the level of money demand?•What determines the level of the money supply?•Why is inflation seen as something to be avoided?Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-4Inflation•In the 1970s, the United States experienced an episode of relatively mild inflation–prices rose between five and ten percent per year–caused significant economic and political trauma•avoiding a repeat of the inflation of the 1970s remains a major goal of economic policyCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-5Figure 8.1 - Post-World War II Inflation in the United States, 1951-2000Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-6The Flexible-Price Model•The Classical dichotomy implies that real variables (real GDP, real investment spending, or the real exchange rate) can be analyzed and calculated without considering nominal variables (price level)–money is “neutral”•This is a special feature of the full-employment flexible-price modelCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-7Money•is wealth that is held in a readily-spendable form•is made up of–coin and currency–checking account balances–other assets that can be turned into cash or demand deposits nearly instantaneously, without risk or costCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-8The Usefulness of Money•Without money, market transactions would have to be performed through barter•In a barter economy, market exchange would require the coincidence of wants–you would have to have some good or service that someone wants and he or she would have to have some good or service that you wantCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-9Figure 8.2 - Coincidence of WantsCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-10The Usefulness of Money•Money also serves as a unit of account–money is used as a yardstick to measure value or quote prices•Anything that alters the real value of money in terms of its purchasing power will also alter the real terms of existing contracts that use the money as a unit of accountCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-11The Demand for Money•Businesses and households have a demand for money–they want to hold a certain amount of wealth in the form of readily-spendable purchasing power to carry out transactions•a higher level of spending means a larger money demand•There is a cost of holding money–cash and checking deposits earn little or no interestCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-12Figure 8.3 - Reasons for and Opportunity Cost of Holding MoneyCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-13The Quantity Theory of Money•assumes that the only important determinant of the demand for money is the flow of spending•can be summarized using–the Cambridge money-demand function–the quantity equationY)(PV1M YPVM Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-14The Quantity Theory of Money•(P  Y) represents the total nominal flow of spending•M is the quantity of money•V is a measure of how fast money moves through the economy–how many times the average unit of money is used to buy a final good or serviceYPVM Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-15Figure 8.4 - The Velocity of MoneyCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-16Determining the Price Level•In the flexible-price model of the macroeconomy–real GDP (Y) is equal to potential GDP (Y*)–the velocity of money is determined by the sophistication of the banking system–the money supply is determined by the central bankMYVP Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-17Determining the Price Level•If the price level is higher than the quantity equation predicts–households and businesses will have less wealth in the form of money than they wish•they will cut back on purchases–sellers will note demand is weak and lower pricesMYVP Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-18Determining the Price Level•If the price level is lower than the quantity equation predicts–households and businesses will have more wealth in the form of money than they wish•they will increase purchases–sellers will note demand is strong and raise pricesMYVP Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.8-19Determining the Price Level•Example (third quarter of 1998)–real GDP = $7,566 billion–money stock = $1,072 billion–velocity = 7.9641.1284$1,072$7,5567.964MYVP •In the third quarter of 1998, the price level was equal to 112.84% of its 1992 levelCopyright © 2002 by The McGraw-Hill