macro lecture 11

8/11/2019 Macro Lecture 11

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MacroLecture11

Money, The Price Level, and Inflation

Lecture Highlights

What determines the DD for money and how the DDfor money and the SS of money determine thenominal interest rate.

In the long run, the quantity of money determines theprice level and money growth brings inflation.

The costs of inflation and the benefits of a stablevalue of money.

The short-run trade off between inflation andunemployment.

Distinguish between the short-run and the long-runPhillips curves.


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Money, The Price Level, and Inflation

The price level and real GDP have resulted fromprevious decisions. When the CB conducts an OMOto change the qty of money, the nominal interest rateis free to adjust until Md = Ms.

Changes in the nominal interest rate also change thereal interest rate (in= ir+ inflation rate). This isbecause the inflation rate is slow to adjust.

Changes in the real interest rate spending plans:

If irI & C

If irI & C

These changes in spendingproduction & prices


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3 short-run situations

MS

Mdo

Md1

Md2

Qty of money

Md depends on the

price level.

in


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Money market equilibrium in long-

run

MS

Mdo

Qty of money

Long-run equilibrium

ir (real interest rate)+ the inflation ratedetermines long-runequilibrium in(nominal interestrate)

in

Inflation rate

Long-run equilibrium ir

Long-run

equilibrium in


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The Quantity Theory of Money

When real GDP equals potential GDP, an increase in the qty of moneybrings an equal percentage increase in the price level is called the qtytheory of money.

The velocity of circulation is the number of times in a year that the averagedollar of money gets used to buy final goods & services.

The value of final goods & services = nominal GDP = real GDP (Y) X price

level (P)Velocity of circulation (V):V = P.Y

___M M = qty of money

e.g. if the GDP deflator = 125125/100 = 1.25

real GDP (Y) = 8 M = 2V = 1.5 X 8

_____ = 62


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Contd.

The equation of exchange:The qty of money (M) X V = P X Y

M.V = P.YV and Y are constant ( in long-run)If M P must increase by the same percentage that M increased.Real GDP, Y = $8 billion

Qty of money, M = $2 billionVelocity of circulation, V = 5P = M.V 2 X 5

___ = _____ = 1.25Y 8

M from $2 billion to $2.4 billionThe percentage increase in M = 2.42

_____ X 100 = 20%2

P from 1.25 to 1.5 the percentage increase in P = 1.5 1.25 X 100 = 20%_______

1.25


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Inflation and the Qty Theory of Money

What determines the inflation rate?

M.V = P.Y

logM + logV = logP + logY

dlogM + dlogV = dlogP + dlogY

dM + dV = dP + dY__ __ ___ ___

M V P Y

Money growth + velocity growth = inflation + real GDP growth

e.g. money growth = 4%/ year

Velocity growth = 1%/ yearReal GDP growth = 3%/ year

4% + 1% = inflation + 3%

Inflation = 2%/ year


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Inflation

Definition

The continual increase in average prices.

The value of money/ purchasing power of

money refers to the amount of goods andservices one ringgit can buy.

Inflation means the value of money is falling

because prices keep rising.


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Causes of inflation

Cost-push inflationoccurs when a firm passes onan increase in production costs to the consumer.

The inflationary effect of increased costs can be theresult of

(i) Increased wages, leading to

- A wage-price spiral, which occurs when priceincreases spark off a series of wage demands whichlead to further price increases and so on.

- A wage-wage spiral, which occurs when one group ofworkers receive a wage increase which sparks off aseries of wage demands from other workers.


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Contd.

(ii) Increased import prices which can be theresult of

- A rise in world prices for imported raw

materials.- A depreciation of ringgit/ domestic currency.

(iii) Increased indirect taxation

- Demand-pull inflationoccurs when there is

too much money chasing too few goodsbecause the demand for current outputexceeds supply.


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Demand-pull inflation

AD

AD

AS

inflation

Pricelevel

output


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Effects of inflation

Advantages

The government finds that people earn moreand so pay more income tax.

Firms are able to increase prices and profitsbefore they pay out higher wages.

Debtors/ borrowers gain because they use

money now, when its purchasing power isgreater.


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Contd.

Disadvantages

People on fixed income.

Creditors/ savers lose because the loan will have

reduced purchasing power when it is repaid. Domestic goods become more expensive than

foreign-made products so the B/P suffers.

Industrial disputes may occur if workers are unable to

secure wage increases to restore their standard ofliving.


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Remedies of inflation

Cost-push remedies

Introduce price and income policies to freeze

price and wage increases.

Encourage an appreciation of ringgit.

Reduce indirect taxation


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Contd.

Demand-pull remedies

Reduce government spending.

Increase income tax to reduce consumerspending.

Reduce peoples ability to borrow money by

increasing interest rates and tightening creditregulations.

Control the supply of money.


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The Phillips Curve

PC

Unemployment rate (%)4 7

2

6

Inflationrate(%/year)

The Phillips curve

illustrates the short-run

relationship between

inflation andunemployment.


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AD, AS, and the Phillips curve

The PC shows the short-run combinations ofunemployment and inflation that arise asshifts in the AD curve move the economyalong the short-run AS curve.

The greater the AD for goods and services,the greater is the economys output, and thehigher is the overall price level.

A higher level of output results in a lowerlevel of unemployment.

(see next slide)


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Contd.

Low AD

High AD

AS

102

106

Y7500 8000

U=7% U=4%

Pricelevel

PC

2

6

Inflationrate

4 7 U(%)


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The Long-run Phillips Curve

In the 1960s, Friedman and Phelpsconcluded that inflation and unemploymentare unrelated in the long-run.

As a result, the long-run PC is vertical at thenatural rate of unemployment.

Monetary policy could be effective in theshort-run but not in the long-run.

(see next slide)


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The Relationship between the PC and

the AD-AS model

MsP inflation rate

But leaves output and unemployment at their

natural rates.

(see next slides)


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Contd.

AD1

AD2P1

P2

Yp

Potential output/ naturalrate of output

Pricelevel Inflation

rateLRPC

LRAS

U*

Natural rate of unemployment

macro lecture 11

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