Section+IV-Summary

Section+IV-Summary - Section IVSummary 1 This section...

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Section IV—Summary 1. This section studies the role of money in the economy. For our purposes money is defined to be a fiat currency that is issued by the country’s central bank in order to avoid barter and make trading less costly. The use of the money as a medium of exchange preserves resources and improves real welfare. However, once a monetary system for trading has been established, the main question is what are the effects of increasing the stock of money marginally—i.e. what are the effects of making the money supply a little higher or a little lower? 2. In a competitive economy with complete information money is neutral —i.e. money has no real effects on output, employment, real wages, etc.. Changes in the money supply simply cause proportional changes in all nominal variables (variables denominated in dollars). The logic is that an increase in the money supply creates an excess supply of money, other things constant. Households with more money than they want to hold as an asset will spend the money on goods and services. The rise in nominal spending will increase the price of goods and services. As the firms attempt to respond to the profit opportunity created by the rising price level they demand more labor and capital services. The economy-wide demand for these factor services drives up nominal wages and nominal rental rates on capital, increasing the nominal costs of production. The rising costs eliminate the profit opportunity and as a result production, employment, and other real variables are unchanged. There is more money in the economy and everything is marked up in terms of their nominal values, but nothing real has changed. 3. The logic above implies that all nominal variables should move proportionally with the money supply. In particular any percentage change in the money supply should generate an equal percentage change in the price level. Another way of saying this is the money growth rate and the inflation rate should have a one-to-one relationship. This is a very precise prediction that can be tested with data on the money supply and prices. The results of such tests consistently
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