Ec 111 1st Edition Lecture 14Outline of Last LectureI. The Fed’s Three Tools of Monetary ControlII. The Federal Funds RateIII. Monetary Policy and the Federal Funds RateIV. Problems Controlling the Money SupplyV. Bank Runs and the Money SupplyVI. Financial Crisis of 2008-2009Outline of Current LectureI. IntroductionII. The Value of MoneyIII. Money SupplyIV. Money DemandV. The Money Supply DiagramVI. A Brief Look at the Adjustment ProcessVII. Real vs Nominal VariablesVIII. Real vs Nominal WageIX. Classical DichotomyX. The Neutrality of MoneyXI. The Velocity of MoneyXII. The Quantity EquationCurrent LectureINTRODUCTION- This chapter introduces the quantity theory of money to explain one of the Ten Principles of Economics from chapter 1o 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 inflationTHE VALUE OF MONEY- P=Price Level (like CPI or GDP Deflator)- Price level is the price of a basket of goods measured in dollars- 1/P is the value of $1, measured in goods- Example: basket contains 1 candy baro If P=$2, value of $1 is ½ candy bar- Inflation drives up prices and drives down the value of moneyMONEY SUPPLY- In the real world, the money supply is determined by Federal Reserve, the banking system and consumers- In this model, we assume the Fed precisely controls money supply and sets at some fixed amountMONEY DEMAND- Money demand refers to how much wealth people want to hold in liquid formo Not income or how much you want to make - Money demand depends on price levelo An increase in price level reduces the value of money so more money is required to buy goods and serviceso Thus quantity demanded of money demand is negatively related to the value of money and positively related to price level, other things equal Other things=real income, interest rates, and availability of ATMs)THE MONEY SUPPLY DIAGRAM- As price level falls value of money rises- The Fed sets Money Supply at some fixed value regardless of price level (makes the curve perfectly elastic)- A fall in value of value of money (or an increase in price level) increases the quantity of money demanded- Price level adjusts to equate quantity of money demanded with money supplyo Equilibrium value of money and price level- Suppose the Fed increases money supplyo Values of money falls as price level risesA BRIEF LOOK AT THE ADJUSTMENT PROCESS- At the initial price level, an increase in money supply causes excess supply of money- People get rid of excess money by spending on goods and services or by loaning to people who spendo Increased demand for goods- Supply of goods does not increase. Prices must rise- Other things happen in short runREAL VS NOMINAL VARIABLES- Nominal Variables: measured in monetary unitso Nominal GDPo Nominal interest rate (rate of return measured in dollars)o Nominal wage- Real Variables: measured in physical unitso Real GDPo Real interest rate (measured in output)o Real wage (measured in output)- Prices are normally measured in terms of money- Relative Price: the price of one good divided by anothero Pizza=$10o CD=$15o So you can get 1.5 Pizzas per CDo Measured in physical units so they are real variablesREAL VS NOMINAL WAGE- An important relative price is the real wageo W=nominal wage=price of labor ($15/hour)o P=price level=price of goods and services ($5/unit of output)- Real wage is the price of labor relative to the price of outputo W/P=15/5=3 units of output per hourCLASSICAL DICHOTOMY - Classical Dichotomy: The theoretical separation of nominal and real variables- Hume and the other classical economists suggested that monetary developments affect nominal variables, but not real- If central bank doubles the money supply, Hume and others contendedo All nominal variables-including prices-will doubleo All real variables-including relative prices-will remained unchangedTHE NEUTRALITY OF PRICE- Monetary Neutrality: the proposition that changes in the monetary supply do not affect real variables- Doubling money supply causes all nominal prices to double- Most economists believe the classical dichotomy and neutrality of money describes the economy in the long runo Monetary changes can have important short run effects on real variablesTHE VELOCITY OF MONEY- Velocity of Money: the rate at which money changes handso PxY=nominal GDP or price level times real GDPo M=Money Supplyo V=Velocityo Velocity=V=PxY/M Average money used in ____ transactionsThe quantity equation - Multiply both sides by M- M*V=P*Y- Called quantity