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# Chapter 13 - CHAPTER 14 Money and the Economy In Chapters...

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CHAPTER 14 Money and the Economy In Chapters 12 and 13 we learned about the monetary system in the United States, both how money is created and how the Federal Reserve conducts its monetary policy. Now that we have established these foundations, we want to find out how changes in the money supply affect the economy. In particular, we want to study the relationship between the money supply and inflation, analyzing the process that links monetary increases to inflation and determining how strong this causal link is. CHAPTER OBJECTIVES Upon completing this chapter, your students should be able to: 1. Explain the equation of exchange. 2. Make predictions based on the simple quantity theory of money. 3. Explain monetarism in an AD-AS framework. 4. Identify the causes of one-shot inflation. 5. Identify the cause of continued inflation. 6. Explain the difference between the liquidity, income, price-level, and expectations effects and explain how each affects the interest rate. KEY TERMS velocity income effect equation of exchange • price-level effect simple quantity theory of money • expectations effect one-shot inflation • nominal interest rate continued inflation • real interest rate liquidity effect 141

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142 Chapter 14 CHAPTER OUTLINE I.MONEY AND THE PRICE LEVEL —The MV-PQ model addresses the relationship between money and price level and between money and nominal GDP. A.The Equation of Exchange —The equation of exchange simply states M × V P × Q where M = the money supply (usually thought of as M1), V = the velocity of money (defined below), P = the price level, and Q = real output, or Real GDP. 1.What Is “Velocity”?— Velocity is the number of times the average dollar is spent to buy final goods and services in a given year . We measure velocity by dividing nominal GDP by the money supply, that is V GDP/M 2.Interpreting the Equation of Exchange —The equation of exchange tells us a number of things. In addition to its literal reading, it tells us that M × V = (nominal) GDP since P × Q = (nominal) GDP, and it also tells us that Total spending (M × V) total sales revenues (P × Q) B.From the Equation of Exchange to the Simple Quantity Theory of Money velocity (V) and real output (Q) are effectively constant in the short run; therefore, any change in the money supply (M) must cause a strictly proportional change in the price level (P) and nominal GDP . The simple quantity theory of money predicts that changes in the money supply will bring about strictly proportional changes in the price level as illustrated in Exhibit 1. For real-world examples of the relationship between money and inflation, see the Economics Around the World feature “Money and Inflation.” The examples in Exhibit 2 show the strong relationship between money supply growth and inflation. C.The Simple Quantity Theory of Money in an AD-AS Framework
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Chapter 13 - CHAPTER 14 Money and the Economy In Chapters...

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