macro lecture 11
TRANSCRIPT
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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