Lecture+11 - Economics 102 Lecture 11: Money and Inflation...

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1 Economics 102 Lecture 11 : Money and Inflation LECTURE 11 MONEY AND INFLATION 1 Money and Inflation § Zimbabwe In May, 2006, a single two-ply sheet of toilet paper cost Z$417 and a roll cost Z$145,750 (Z$ = Zimbabwe dollars). The annual inflation rate was 1000 percent. Today, the Zimbabwe inflation rate is above 4,500 percent and the economy is devastated. § What is the cause of this very high rate of inflation? LECTURE 11 MONEY AND INFLATION 2 In this lecture, look for the answers to these questions: § How does the money supply affect inflation? § Does the money supply affect real variables like real GDP or the real interest rate?
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2 LECTURE 11 MONEY AND INFLATION 3 Introduction § This chapter introduces the quantity theory of money to explain one of the Ten Principles of Economics from Chapter 1: Prices rise when the government prints too much money. § Most economists believe the quantity theory is a good explanation of the long run behavior of inflation. LECTURE 11 MONEY AND INFLATION 4 The Value of Money § P = the price level ( e.g. , the CPI or GDP deflator) P is the price of a basket of goods, measured in money. § 1/ P is the value of $1, measured in goods. § Example: basket contains one candy bar. If P = $2, value of $1 is 1/2 candy bar If P = $3, value of $1 is 1/3 candy bar § Inflation is an increase in the overall price level; consequently, inflation means a decline in the value of money. LECTURE 11 MONEY AND INFLATION 5 The Quantity Theory of Money § The quantity theory of money is the proposition that, in the long run, the quantity of money determines the price level and the rate of growth of the quantity of money determines the rate of inflation. § We study this theory using two approaches: 1. a supply-demand diagram 2. the quantity equation
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3 LECTURE 11 MONEY AND INFLATION 6 Money Supply (MS) § In real world, determined by Federal Reserve, the banking system, consumers. § In this model, we assume the Fed precisely controls MS and sets it at some fixed amount. LECTURE 11 MONEY AND INFLATION 7 Money Demand (MD) § Refers to how much wealth people want to hold in the form of money. § Depends on P : An increase in P reduces the value of money, so more money is required to buy G&S. § Thus, quantity of money demanded is negatively related to the value of money and, thus, positively related to P , other things equal. (These “other things” include real income, interest rates, and availability of ATMs.) LECTURE 11 MONEY AND INFLATION 8 The Money Supply-Money Demand Diagram Value of Money, 1/ P Price Level, P Quantity of Money 1 1 ¾ 1.33 ½ 2 ¼ 4 As the value of money rises, the price level falls.
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4 LECTURE 11 MONEY AND INFLATION 9 The Money Supply-Demand Diagram Value of Money, 1/ P Price
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This note was uploaded on 04/02/2008 for the course ECON 102 taught by Professor Rossana during the Fall '08 term at University of Michigan.

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Lecture+11 - Economics 102 Lecture 11: Money and Inflation...

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