Lecture 16: Money and the Price Level I L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.10 2 March 2010

Introduction Last time: – Completed Economic Fluctuations topic by explaining fluctuations in unemployment – Arise due to natural unemployment rate varying over the business cycle Today – Begin new topic on money – Consider money demand and supply

Where are we going Want to incorporate money demand in to the model – So far ignored the issue: assumed that household held a constant amount of money used to fund transactions Understand pattern of prices and inflation – History suggests price variation can change radically – Controlling inflation has been a key policy issue for modern governments

Money People get confused about money – Think outcomes of models will change when we introduce money – Silly ideas around, such as the idea that banks can ‘create’ money – Disconnect the ‘monetary economy’ from the model of output, incomes, wages etc – Real story is actually much more simple

Concepts of Money Without money, you have barter – People exchange goods for goods – Complicated, messy and inconvenient Money is a medium of exchange – Households are willing to accept money in lieu of goods and services: money stores value – Households can access this value when they want to by exchanging it for goods / services

Concepts of Money Money itself is just paper: ‘fiat money’ – Historically, people have used valuable commodities as money (e.g. gold) because of lack of legal enforcement of fiat money – Use ‘commodity money’ so if society non longer recognises value of commodity as money, it has some intrinsic value (e.g. as gold) – Commodity money is a waste of resource – We will only consider fiat money

Money Demand There is an opportunity cost to holding money – It could be invested in bonds or capital – But you need it to carry out transactions (buy goods, new capital, new bonds) – Trade-off: if you hold more money, you have it available for transactions and don’t need to incur the cost of going to the bank so often – If you hold less money, you earn more interest at the bank

Money Demand What affects this decision – Interest rate: if the interest rate is higher, you want to hold less money and put more in the bank (where it earns interest) – Price level: if prices are higher, you need more money to service transactions – Output: if you have more output (income), you need more money to exchange the higher level of output

Money Demand Function So we can establish a general function Often express this in real terms. If prices double, money held doubles, so in real terms no change occurs: Empirical studies suggest this is accurate

Equilibrium Price Level What about supply of money? – Money supply is fixed by the government. – They print a certain amount of money so that transactions can take place easily – Needs to be divisible (so prices can be easily divisible) – So price of goods change due to changes in demand and supply

M s =M d Changing money supply changes the price level in the economy – E.g. government doubles amount of printed money in economy and distributes it randomly – Everyone has more nominal money, demand for everything doubles – Prices double, wages doubles, rents double – So in real terms nothing changes – Money is neutral, hence term ‘money neutrality’

Money Neutrality This is essentially a simple idea – Money is just paper currency. The price of a good in isolation doesn’t mean anything, it is only the price of one good relative to another that matters – So if everyone is given more money (but continues to buy the same goods) all prices double – Relative prices are unchanged. – Nothing has changed

Money Illusion This would not be the case if – People got confused between the nominal value (£) of things and the real value – E.g. people only worry about their wage in £ – When prices double, they don’t realise that their wages are worth less, so don’t negotiate – This is called money illusion

Summary Created model of money demand and supply – Trade-off between holding money and buying bonds instead – When prices rise, money holdings rise 1:1, so no effect on real money balance – When money supply rises, prices rise 1:1, all real variable unchanged, no effect on activity Next time: Examine changes in money demand