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CSUN BUS 302 - Macroeconomics

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MacroeconomicsTopic 7: “Know the equation of exchange andthe connection between money and inflation.”Reference: Gregory Mankiw’s Principles of Macroeconomics, 2nd edition, Chapter 16.The Equation of ExchangeThe equation of exchange (also called the quantity equation) is commonly used toexpress the classical theory of inflation. The equation of exchange is often derived fromthe definition of velocity of money. Velocity is the average rate at which money changeshands in the economy. More specifically, if we let V be velocity, M be a statisticmeasuring the money supply, P be the price level as measured by the GDP deflator, andY be real GDP, then:MYPV×=orMV = PYClassical economists used this equation to argue that an increase in the money supply waslikely to cause a proportionate increase in the cost of living (i.e., the price level). To getthis conclusion they typically would make the following observations:1. Over a short period of time the velocity of money changes little.2. Because velocity is relatively stable, increases in M are likely to change nominalGDP (P x Y).3. Real GDP (Y) is typically determined by the amount of labor, capital, and naturalresources used in the economy as well as by the level of technology. Since none of theseitems change when money is printed, it is not likely that changing the money supply willchange real GDP.4. Given that V and Y are constant, increasing M causes a proportionate increase inP.This conclusion is often illustrated using a money demand and supply diagram thatemphasizes the relationship between money demand and the value of money. The valueof money refers to the buying power of a piece of currency. When prices are high,people can’t afford to buy as much. Hence, the value of money is inversely related to theprice of goods.Figure 1 shows the effect of an increase in the money supply in this diagram. When theMoney Supply is increased the corresponding curve shifts from MS1 to MS2. The pricelevel rises from 2 to 4 and the value of money drops from ½ to ¼. The reasons whyprices rise (and the value of money falls) are called the adjustment process. This processis most easily envisioned by imagining the effect of helicopters dropping large sums ofmoney on the US. People would pick up that money and have two choices: use themoney to buy goods and services, or put the money in the bank. If the money is used tobuy goods and services, the demand for those goods and services increase, causing pricesto rise. If the money is put in the bank, then the banks have more money to lend. Thiscauses the banks to reduce interest rates to attract new borrowers. The new borrowersuse the money to buy durable items such as cars and houses. This increases demand forthose products, causing prices to rise. Thus, whether money from the helicopter drop isspent on goods and services or put in the bank, the price level will tend to rise when themoney supply is increased.The Classical DichotomyClassical economists make a strong distinction between variables measured in dollarterms (called nominal variables) and variables measured in physical terms (called realvariables). This separation between nominal and real variables is called the classicaldichotomy. This distinction is useful because different things affect nominal and realvariables. In particular, the theory of money neutrality maintained that increasing themoney supply would only change nominal variables, but would not affect real variables.These days most economists accept the notion of money neutrality in the long run, but itis highly questionable during briefer periods of time.The Fisher EffectQuantityOf MoneyValue ofMoney (1/P)Price Level(P)MoneyDemandMS11/22Figure 1(Corresponds to Figure 16-2 in the Mankiw Text)MS2A1/44BM1M2One example of the classical dichotomy occurs in the discussion of the Fisher Effect.According to the Fisher Effect, increasing the growth rate of the money supply does notaffect the real interest rate, but because inflation will eventually occur, people begin toexpect inflation, causing the nominal interest rate to rise. The nominal interest ratemeasures the percentage increase in money loaned over the course of a year. The realinterest rate measures the percentage increased in the buying power of the money loanedover the course of the year. As a consequence:the Real Interest Rate ≈ the Nominal Interest Rate – the Inflation RateThe Fisher Effect uses the definition of the real interest rate given above and theproposition of money neutrality. Increasing the rate of growth in the money supply raisesthe inflation rate and leaves the real interest rate the same. The nominal interest rate willrise by the same amount as the increase in inflation.Costs of InflationInflation is costly, but not for the reasons typically identified by the non-economist. Mostpeople believe that inflation reduces the earning power of their wages. Actually, whenmoney is printed, all prices rise – including most wage rates. In the end, everything ismore expensive, but incomes are greater too. Most economists believe that the real costsof inflation are the items in the list below.Shoeleather costsPeople try to avoid keeping money in their pockets when inflation is high. One can, forexample, keep most of your assets in interest earning accounts by making tinywithdrawals of cash for each purchase that is made. This requires many trips to the bank(presumably wearing out your shoes). These extra trips to the bank are costly, but theydo reduce your exposure to inflation.Menu Costs:Firms must reprint catalogs and menus much more frequently during inflationary times.Tax Rate DistortionsTaxes will always reduce economic efficiency, but many taxes become bigger problemsin inflationary times. For example, suppose that you buy some stock in 1990 for $100and sell it in the year 2000 for $200. According to US tax law you had a $100 capitalgain that will be taxed. If there was a lot of inflation, you might actually be able to buyless with $200 in 2000 than $100 bought in 1990. Thus a real loss would be taxed as alarge nominal gain. This means that inflation is increasing the disincentive to buy stockimplicit in the capital gains tax.Confusion and InconvenienceInflation doesn’t tend to be steady. In countries that experience hyperinflation, forexample, inflation rates may vary from 30% to 50% on a month-to-month basis. Thismuch uncertainty about how much value money will


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CSUN BUS 302 - Macroeconomics

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