Introduction to Macroeconomics Chapter 17 Money Growth and Inflation

Price Level and Value of Money When the price of a good rises – people need more money to pay for it Since they need more money to buy the same good – the value of each dollar declines As prices rise  value of money falls P = Price Level 1/P = Value of Money

Understanding Quick Check Your favorite coffee beverage costs you $4 per cup. Your value of money is ____. One day, you go into your favorite coffee shop and the coffee now costs $5. Your value of money now is ____ and you are ____. ¼, 1/5, better off ¾, 4/5, better off ¼, 1/5, worse off ¾, 4/5, worse off

Money Supply and Money Demand Money supply (MS) is determined mainly by the Federal Reserve Quantity of money is fixed Money demand (MD) reflects how much wealth people want to hold in a liquid form Main determinant: Price level At high prices – people need to hold more money in liquid form for their transactions MD is high when value of money is low

Prices adjust to bring MD = MS Money Equilibrium Prices adjust to bring MD = MS People will adjust how much money they must hold in response to price change

Prices adjust to bring MD = MS Money Equilibrium Prices adjust to bring MD = MS People will adjust how much money they must hold in response to price change

Prices adjust to bring MD = MS Money Equilibrium Prices adjust to bring MD = MS People will adjust how much money they must hold in response to price change

Application 1 Suppose the Fed decides to increase the money supply through open market operations. It decides to buy bonds from the public. Graph the Md-Ms diagram Illustrate the change this policy will have on the money market. What happens to the new equilibrium price level, value of money and equilibrium quantity of money? In the interim (before price level adjusts), is there a surplus or shortage of money?

Coping with Surplus of Money When there is a surplus of money, people try to get rid of it: Buying more goods and services  Increase in demand Putting money in the loanable funds market  more loans available  Increase in demand for goods Both cases: Increase in demand leads to increase in prices ↑MS = ↑ demand = ↑ prices

Application 2.a Suppose credit cards become more readily available to the general adult population, making it easier to purchase goods and services without carrying cash around everywhere. Graph the Md-Ms diagram Which curve shifts and why? Illustrate the change this will have on the money market. What happens to the new equilibrium price level, value of money and equilibrium quantity of money?

Application 2.b In response to the previous scenario, the Fed becomes concerned about inflation and prefers to keep the price level at P* (original price level). What can the Fed do with the money supply to impact the money market? On a new graph, illustrate this change and discuss what happens with the value of money, inflation, and quantity of money

Classical Dichotomy Refers to the separation of nominal and real variables Nominal Variables: Measured in monetary terms The price of an apple is $2 The price of a banana is $1 Real Variables: Measured in physical units (or relative terms) The price of an apple is 2 bananas The price of a banana is ½ apple Changes in the money supply – Nominal changes Monetary Neutrality: Changes in the money supply will not impact real variables

The Velocity of Money P x Y V = M Quantity Equation : M x V = P x Y Velocity of money: the rate at which money changes hands Notation: P x Y = nominal GDP = (price level) x (real GDP) M = money supply V = velocity Velocity of money : The textbook’s definition of velocity appears on this slide. You may prefer a more precise definition: The number of transactions in which the average dollar is used. The following slide provides a simple example to clarify the meaning of velocity. V = P x Y M Quantity Equation : M x V = P x Y 13

Application 3 Suppose we have the following values: Suppose we have the following values: Y = $5000; V = 5; M = $2000; P = 2 Calculate the quantity equation If money supply increases to $3000, how would prices change to keep the quantity equation true? If money supply increases to $3000, how would real GDP change to keep the quantity equation true? If money supply increases to $3000, how would velocity change to keep the quantity equation true? Which variables do we know will not change (based on monetary neutrality)? Which variable do you think must change in response to the change in money supply? 14

Real i = nominal i – inflation Fischer Effect Nominal interest rates adjust one-for-one to the inflation rate Real i = nominal i – inflation Change in inflation  impacts nominal interest rate not real interest rate Important implications for taxing interest income, debt repayment, and savings

Application 4 Suppose Country A and Country B both set taxes on interest income to 20%. Country A’s inflation is 1%, Country B’s inflation is 10%. Complete the following table: Which country is likely to have lower savings rates? Country A Country B Real Interest Rate 3% Inflation Rate 1% 10% Nominal Interest Rate Reduction in Nominal Interest from 20% tax After-tax Nominal Rate After-tax Real Rate

Application 5 Suppose a student has $20,000 of debt with a 7% nominal interest rate. The debt compounds over 10 years. What is the nominal value of that debt? What is the real value of that debt if…. Inflation is very high (20%)? If there is deflation (-20%)? Is inflation good for borrowers or lenders? Is deflation good for borrowers or lenders?

Key Takeaways Money growth influences price levels and inflation in the economy Since money is a nominal variable, changes in MS it will have no impact on real variables such as real GDP, unemployment, relative prices, ect. Can use both the MD-MS graph and quantity equation to describe this relationship Inflation is costly, but deflation is worse!