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ECON 0280 Lecture Notes 10 Part 1

ECON 0280 Lecture Notes 10 Part 1 - ECON 0280 Money and...

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ECON 0280 Money and Banking Lecture Notes for Topic 10 (Part 1) Theories of Monetary Policy Classical Model: Smith (1776 – 1936) Perfect information and flexible wages/prices: markets reach equilibrium rapidly. Quantity theory of money: Changes in money cause changes in prices. Developed to explain how the increase in gold from the new world would affect the economy of Europe, as gold was money. Equation of exchange: MV=PY P is the price level. Y is the level of real output/income, i.e. real GDP. PY is nominal income: the dollar value (P) of the output (Y) produced by this economy, i.e. nominal GDP. Velocity (V) is the turnover of the money supply; how many times each dollar is used to buy the nominal income of the economy. Example: Nominal income=$1200, M=$100, then each dollar was used an average of 12 times; V=12. Deriving AD : Hold M constant at 600, assume V=2. Therefore PY=1200. Plotting combinations of P and Y that equal 1200 yields downward sloping AD. AD shifts if Ms changes. Equation of exchange is true by definition. Quantity theory requires some theories about where M, V, P, and Y come from. Velocity is determined by the paying habits of society and relates to money demand. Classical economists believed that it is independent of the money supply and thus V is constant when M changes. Real output (Y) is determined by supply factors: population, technology, capital stock, etc. Changes in money do not affect these supply factors. Aggregate supply (AS) is vertical at what is often called the natural rate of output. Supply determines output. Say’s Law: supply creates its own demand. The act of production provides income which thus creates demand. Recall that AD=C+I+G. Interestingly, in the classical model only a change in M or V will shift AD---the classical loanable funds theory argued that other changes such as an increase in C or G would not lead to a change in overall AD, due to crowding out effects. For example, a fiscal policy (such as higher G) would lead to more government borrowing which drives up interest rates; this higher interest rate would lead to a corresponding decrease in C and I to leave the net level of C+I+G at the original level.
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Effects of a change in Ms: Recall Assumptions. An increase in money will increase aggregate demand (AD shifts right), the higher demand will drive up prices; workers will respond to higher prices by demanding higher wages; which drives up production costs. The end result is that the increase in prices (which induces Qs to increase) is counterbalanced by an increase in production costs (which induces Qs to decrease). Aggregate supply is unchanged and is thus vertical at the level of output determined by the productive capacity of the economy. The increase in the money supply leads to an increase in prices. Therefore, a change in M will cause a change in prices only: this is the quantity theory of money.
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