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Unformatted text preview: Chapter 9 Money, The Price Level and Interest rates Money and the Price Level
Equation of Exchange: MV PQ Where M= money supply V= Velocity P=price level Q=Real GDP Velocity: the average number of times a dollar is spent to buy final goods and services in a year. Interpreting the Equation of Exchange
• The money supply multiplied by velocity must equal the price level times Real GDP: M x V PxQ • The money supply multiplied by velocity must equal GDP: M x V GDP • Total spending or expenditures (measured by MV) must equal the total sales revenues of business firms (measured by PQ): MV PQ to hold q constant, you are holding real GDP constant, you are assuming long run EQ, SRAS = LRAS From the Equation of Exchange to the Simple QTM
• Fisher and Marshall assumed changes in velocity are so small that for all practical purposes velocity can be assumed to be constant.
fisher and marshall belong to the traditional monitorism simple quantity theory of money • Fisher and Marshall assumed Real GDP is fixed in the short run. • From these assumptions, we have the simple quantity theory of money: changes in M will bring about proportional changes in P. Quantity Theory of Money
Assumptions: V is constant = V GDP at full employment = Q Thus, MV = PQ A proportional change from M to P the government should keep money supply constant Main Implication of the QTM
• The central bank, which controls the money supply, has ultimate control over the rate of inflation. • If the central bank keeps the money supply stable, the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly. the ad curve slopes down, the SRAS mimics the LRAS because it is completely vertical because something is fi in the long run, the money supply can only affect the output and unemployment they said that increasing the money supply would only increase inflation The Simple QTM in an AD-AS Framework
• • • • • MV is equal to total expenditures. Total expenditures is equal to C+I+G+(EX-IM) Since MV=TE, MV=C+I+G+(EX-IM) A change in the money supply or a change in velocity will change aggregate demand and therefore lead to a shift in the AD curve. • In the simple quantity theory of money, velocity is assumed to be constant, thus only M can affect AD. Diagrammatically…. Dropping the Assumptions that V and Q are Constant
changed to be that V is predictable not constant, it moves in predictable moves, Q can move, what is behind inflationary or recession-ary gaps • Remember: M x V P x Q, then P=MxV Q • Money supply, velocity, and Real GDP determine the Price Level. • An increase in M or V or a decrease in Q will cause prices to rise. This is inflation. • A decrease in M or V or an increase in Q will cause prices to fall. This is deflation.
no longer a proportional relationship between from m to p Modern Monetarism
Assumptions: V is not constant, but predictable GDP not always at full employment Thus, MV = PQ A non- proportional change from M to P in the monetarism school of thought, it is thought that the supply of market effects the AD, they focus on the money market with classical, can only change by changes in money supply, modern is money supply or v Monetarism: Key Views
• Velocity changes in a predictable way. • Aggregate Demand depends on the money supply and on Velocity. • The SRAS curve is upward sloping.
LRAS is vertical, AD is downward sloping • The Economy is Self-Regulating (Prices and Wages are flexible) use SRAS to restore long run EQ rather than the AD Diagrammatically….. The Monetarist View of the Economy
• The economy is self-regulating. • Changes in velocity and the money supply can change aggregate demand. • Changes in velocity and the money supply will change the price level and Real GDP in the short run, but only the price level in the long run. The Monetarist View of the Economy
• Changes in velocity are not likely to offset changes in the money supply. • An increase in the money supply will raise aggregate demand and increase both Real GDP and the price level in the short run and increase the price level in the long run. • A decrease in the money supply will lower aggregate demand and decrease both Real GDP and price level in the short run and decrease price level in the long run. Money and Interest Rates
What economic variables are affected by a change in the money supply?
• • • • The supply of loans Real GDP The price level The expected inflation rate en market operation to affect the money supply, the government sells assets in exchange for money, this sale ll decrease the money supply - this is an open market sale... an open market purchase is when the government ys bond and gives out money. this all affects the loanable funds market AD shifts outward will cause an increase in real GDP, an increase in real GDP means an increase in income, as get more money they save more, this is saying C is constant, there is a robust business climate which causes increase in I which means you demand more loanable funds to pay for the I the money supply will increase causing the price level to increase, this erodes you purchasing power, which means that you can buy less with your money, which is real income goes down, people borrow more to finance their consumption, this means you nominal income is held constant an increase in higher price, you expect a higher rate of inflation to buy stuff. households may reduce savings so that they can consume more today so they can buy more before prices rise, some people may ha borrow more to buy more today, which means an increase in the demand of loanable funds Money and Interest Rates
A change in the money supply creates a change in interest rates due to a change in: Liquidity Effect: the supply of loanable funds. Income Effect: Real GDP. Price Level Effect: the price level. Expectations Effect: the expected inflation rate. • • • • Anything that affects either the supply of loanable funds or the demand for loanable funds will obviously affect the interest rate. This happens in 4 ways:
• • Liquidity effect: Change in roi because of a change in supply of loanable funds Income effect: When real GDP rises, demand for loanable funds rises more than the supply of loanable funds which leads to a rise in roi Price level effect: Price increase leads to a fall in purchasing power. The demand for loanable funds may increase which causes a rise in roi Expectations effect: When expected inflation rises, demand for loanable funds increases but supply decreases. Thus roi rises • • Expectations Effect
If inflation is expected to increase
• Households may reduce their savings to make purchases before prices rise • Supply shifts to the left, raising the equilibrium rate • Also, households and businesses may borrow more to purchase goods before prices increase • Demand shifts outward, raising the equilibrium rate Diagrammatically…… The Nominal and Real Interest Rates
• Nominal interest rate: the interest rate actually charged (or paid) in the market; the market interest rate. • The Real Interest Rate: the Nominal Interest Rate minus the Expected Inflation Rate. these reflect the real cost of borrowing or the actual cost of borrowing, this factors in the inflation. this was made in an equation called the fishe equation it is nominal interest rates - exp inflation, real interest rates = nominal interest / p, look at wills notes. the expectation effect or the fis effect, the effect on real interest rate is that it goes down so people dema more loanable funds, and the lender doesnt want to lend because he gets less he gets less in return for his loan. ...
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This note was uploaded on 11/28/2010 for the course ECON 201 taught by Professor Dr.sharma during the Spring '08 term at Ohio State.
- Spring '08
- Interest Rates