2. The Classical Theory of Inflation
Quantity theory of money (J S Mills, I Fischer, von Mises)
Quantity of money available
Ultimately determines the price level
P = (M x V) / Y = M * constant
Growth rate in quantity of money available
Determines the inflation rate
Δ M = Δ P * constant

3. Nominal GDP, quantity of money, & velocity of money3
Nominal GDP, quantity of money, & velocity of money
This figure shows the nominal value of output as measured by nominal GDP, the quantity of money as measured by M2, and the velocity of money as measured by their ratio. For comparability, all three series have been scaled to equal 100 in Notice that nominal GDP and the quantity of money have grown dramatically over this period, while velocity has been relatively stable.

4. GDP Deflator and Real GDP Growth
GDP Deflator - Inflation
Real GDP (Economic) Growth

5. The long-run aggregate-supply curve4
The long-run aggregate-supply curve
Price
Level
Long-run
aggregate
supply
Natural rate
of output P1
1. A change
in the price
level . . .
does not affect
the quantity of goods
and services supplied
in the long run P2
Quantity of Output
In the long run, the quantity of output supplied depends on the economy’s quantities of labor, capital, and natural resources and on the technology for turning these inputs into output. Because the quantity supplied does not depend on the overall price level, the long-run aggregate-supply curve is vertical at the natural rate of output.

6. Figure 11-5 Classical Theory and Increases in Aggregate Demand

7. A contraction in aggregate demand8
A contraction in aggregate demand
Short-run
aggregate
supply, AS1
Price
Level
Long-run
aggregate
supply Y1
but over time, the short-run aggregate-supply curve shifts . . .
Aggregate demand, AD1
AS2 P1 A
AD2 P2 B
and output returns
to its natural rate. P3 C Y2
A decrease in
aggregate demand . . .
causes output to fall in the short run . . .
Quantity of Output
A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1 to Y2, and the price level falls from P1 to P2. Over time, as the expected price level adjusts, the short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the economy reaches point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve. In the long run, the price level falls to P3, and output returns to its natural rate, Y1.

8. The short-run aggregate-supply curve6
The short-run aggregate-supply curve
Price
Level
Short-run
aggregate
supply P1 Y1
1. A decrease
in the price
level . . . P2 Y2
reduces the quantity of goods and services supplied in the short run
Quantity of Output
In the short run, a fall in the price level from P1 to P2 reduces the quantity of output supplied from Y1 to Y2. This positive relationship could be due to sticky wages, sticky prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary.

9. Figure 11-8 Real GDP and the Price Level, 1934–1940

10. Figure 11-7 Demand-Determined Equilibrium Real GDP at Less Than Full Employment
Keynes assumed prices will not fall when aggregate demand falls

11. Tradeoff between Inflation and Unemployment?6
Tradeoff between Inflation and Unemployment?
Annual data from 1961 to 1968 shows a negative relationship between inflation and unemployment (inflation = stimulative monetary (M1) and fiscal (G) policy)

12. But in the LongRun – is there any effect?
This figure shows annual data from 1972 to 1981 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). In the periods 1973–1975 and 1978–1981, increases in world oil prices led to higher inflation and higher unemployment.

13. The long-run equilibrium7
The long-run equilibrium
Price
Level
Long-run
aggregate
supply
Natural rate
of output
Short-run
aggregate
supply
Aggregate
demand
Equilibrium
price A
Quantity of Output
The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve (point A). When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level. As a result, the short-run aggregate-supply curve crosses this point as well.