CHAPTER 5 tion Its Causes Effects and Social C A PowerPoint Tutorial To Accompany MACROECONOMICS 8th Edition N Gregory Mankiw Tutorial written by Mannig J Simidian B A in Economics with Distinction Duke University Chapter 1 M P A Harvard University Kennedy School of Government Five M B A Massachusetts Institute of Technology MIT Sloan School of Management Hyperinflation is defined as inflation that exceeds 50 percent per month which is just over 1percent a day Chapter Five Costs such as shoe leather and menu costs are much worse with hyperinflation and tax systems are grossly distorted Eventually when costs become too great with hyperinflation the money loses its role as store of value unit of account and medium of exchange Bartering or using commodity money becomes prevalent The quantity equation is an identity the definitions of the four variables make it true If one variable changes one or more of the others must also change to maintain the identity The quantity equation we will use from now on is the money supply M times the velocity of money V which equals price P times the number of transactions T Money Velocity Price Transactions M V P T V in the quantity equation is called the transactions velocity of money This tells us the number of times a dollar bill changes hands in a given period of time Chapter Five Transactions and output are related because the more the economy produces the more goods are bought and sold If Y denotes the amount of output and P denotes the price of one unit of output then the dollar value of output is PY We encountered measures for these variables when we discussed the national income accounts Money Velocity Price Output M V P Y This version of the quantity equation is called the income velocity of money which tells us the number of times a dollar bill enters someone s income in a given time Chapter Five Let s now express the quantity of money in terms of the quantity of goods and services it can buy This amount M P is called real money balances Real money balances measure the purchasing power of the stock of money A money demand function is an equation that shows the determinants of real money balances people wish to hold Here is a simple money demand function M P d k Y where k is a constant that tells us how much money people want to hold for every dollar they earn This equation states that the quantity of real money balances demanded is proportional to real income Chapter Five The money demand function is like the demand function for a particular good Here the good is the convenience of holding real money balances Higher income leads to a greater demand for real money balances The money demand equation offers another way to view the quantity equation MV PY where V 1 k This shows the link between the demand for money and the velocity of money When people hold a lot of money for each dollar of income k is large money changes hands infrequently V is small Conversely when people want to hold only a little money k is small money changes hands frequently V is large In other words the money demand parameter k and the velocity of money V areChapter opposite sides of the same coin Five The Thequantity quantityequation equationcan canbe beviewed viewedas asaadefinition definition ititdefines definesvelocity velocityVVas asthe theratio ratioof ofnominal nominalGDP GDP PY PY to tothe thequantity quantityof ofmoney moneyM M But But ififwe wemake makethe the assumption assumptionthat thatthe thevelocity velocityof ofmoney moneyisisconstant constant then thenthe thequantity quantityequation equationMV MV PY PYbecomes becomesaauseful useful theory theoryof ofthe theeffects effectsof ofmoney money The Thebar barover overthe theVV means meansthat thatvelocity velocityisisfixed fixed MV PY Chapter Five So let s hold it constant Remember a change in the quantity of money causes a proportional change in nominal GDP Three building blocks that determine the economy s overall level of prices The factors of production and the production function determine the level of output Y The money supply determines the nominal value of output PY This follows from the quantity equation and the assumption that the velocity of money is fixed The price level P is then the ratio of the nominal value of output PY to the level of output Y Chapter Five In other words if Y is fixed from Chapter 3 because it depends on the growth in the factors of production and on technological progress and we just made the assumption that velocity is constant MV PY or in percentage change form Change Changein inM M Change Changein inVV Change Changein inPP Change Changein inYY if V is fixed and Y is fixed then it reveals that Change in M is what induces Changes in P The quantity theory of money states that the central bank which controls the money supply has the ultimate control over the inflation rate If the central bank keeps the money supply stable the price level will be stable If the central bank increases the money supply rapidly the price level will rise rapidly Chapter Five The Therevenue revenueraised raisedthrough throughthe theprinting printingof ofmoney moneyisiscalled called seigniorage seigniorage When Whenthe thegovernment governmentprints printsmoney moneyto tofinance finance expenditure expenditure ititincreases increasesthe themoney moneysupply supply The Theincrease increasein in the themoney moneysupply supply in inturn turn causes causesinflation inflation Printing Printingmoney moneyto to raise raiserevenue revenueisislike likeimposing imposingan aninflation inflationtax tax Chapter Five Chapter Five Economists Economistscall callthe theinterest interestrate ratethat thatthe thebank bankpays paysthe the Nominal Nominalinterest interestrate rateand andthe theincrease increasein inyour yourpurchasing purchasingpower powerthe the real realinterest interestrate rate r i This Thisshows showsthe therelationship relationshipbetween betweenthe thenominal nominalinterest interestrate rate and andthe therate rateof ofinflation inflation where whererrisisreal realinterest interestrate rate iiisisthe the nominal nominalinterest interestrate rateand and isisthe therate rateof ofinflation inflation and andremember remember that that isissimply simplythe thepercentage percentagechange changeof ofthe theprice pricelevel levelP P Chapter Five The Fisher Equation illuminates the distinction between the real and nominal rate of interest Fisher Equation i r The one to one relationship between the