The Money Supply Demand Diagram Value of Money 1 P A fall in value of money or increase in P increases the quantity of money demanded Price Level P 1 33 1 2 4 MD1 Quantity of Money 1 The Money Supply Demand Diagram Value of Money 1 P MS1 P adjusts to equate quantity of money demanded with money supply Price Level P 1 eq m value of money A 1000 1 33 1 2 4 eq m price level MD1 Quantity of Money The Effects of a Monetary Injection Value of Money 1 P MS1 MS2 Price Level P 1 Suppose the Fed increases the money supply eq m value of money 1 Then the value of money falls and P rises 1 33 2 4 eq m price level MD1 Quantity of Money A B 1000 2000 Real vs Nominal Variables Nominal variables are measured in monetary units examples nominal GDP nominal interest rate rate of return measured in nominal wage per hour worked Real variables are measured in physical units examples real GDP real interest rate measured in output real wage measured in output Real vs Nominal Wage An important relative price is the real wage W nominal wage price of labor e g 15 hour P price level price of g s e g 5 unit of output Real wage is the price of labor relative to the price of output W P 3 units output per hour 5 unit of output 15 hour The Classical Dichotomy Classical dichotomy the theoretical separation of nominal and real variables Hume and the classical economists suggested that monetary developments affect nominal variables but not real variables If central bank doubles the money supply Hume classical thinkers contend all nominal variables including prices will double all real variables including relative prices will remain unchanged The Neutrality of Money Monetary neutrality the proposition that changes in the money supply do not affect real variables Similarly the real wage W P remains unchanged so quantity of labor supplied does not change quantity of labor demanded does not change total employment of labor does not change The same applies to employment of capital and other resources Since employment of all resources is unchanged total output is also unchanged by the money supply The Velocity of Money Velocity of money the rate at which money changes hands Notation P x Y nominal GDP price level x real GDP money supply velocity M V Velocity formula V P x Y M The Velocity of Money Velocity formula V Example with one good pizza In 2006 P x Y M real GDP 3000 pizzas price level price of pizza 10 P x Y nominal GDP value of pizzas 30 000 money supply 10 000 velocity 30 000 10 000 3 The average dollar was used in 3 transactions Y P M V The Quantity Equation Velocity formula V P x Y M Multiply both sides of formula by M M x V P x Y Called the quantity equation The Quantity Theory in 5 Steps Start with quantity equation M x V P x Y 1 V is stable 2 So a change in M causes nominal GDP P x Y to change by the same percentage 3 A change in M does not affect Y money is neutral Y is determined by technology resources 4 So P changes by same percentage as P x Y and M 5 Rapid money supply growth causes rapid inflation The Fisher Effect Rearrange the definition of the real interest rate nominal interest rate inflation rate real interest rate The real interest rate is determined by saving investment in the loanable funds market Money supply growth determines inflation rate So this equation shows how the nominal interest rate is determined The Fisher Effect nominal interest rate inflation rate real interest rate In the long run money is neutral so a change in the money growth rate affects the inflation rate but not the real interest rate So the nominal interest rate adjusts one for one with changes in the inflation rate This relationship is called the Fisher effect after Irving Fisher who studied it HAPTER 17 MONEY GROWTH AND INFLATION U S Nominal Interest Inflation Rates The close relation between these variables is evidence for the Fisher effect Percent per year 15 12 9 6 3 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Nominal interest rate Inflation rate
View Full Document
Unlocking...