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# slides06 - 1 Money Prices and Inflation Part 1 Introduction...

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1 [Classical Monetary Theory - P.1] Money, Prices, and Inflation Part 1: Introduction • Famous statement by Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.” • Definition: Inflation Rate = Rate of change in the level of Consumer Prices - Symbols: Price level P. Inflation rate π . Compute: π t = (P t -P t-1 )/P t-1 . • Relation of actual inflation and expected inflation ( π e ): - If inflation is persistent, expectations adjust: π e = π (expected=actual) - If inflation fluctuates, some of the changes are likely unexpected. • Nominal interest rate = Real interest rate + Expected inflation: i = i r + π e . • Classical line of argument: Separate nominal and real variables. - Real interest rate and real output are determined by real factors. - Money determines nominal variables: M => P => π => π e => i

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2 [Classical Monetary Theory - P.2] The Bigger Picture: A Brief History of Macroeconomics • Keynesian Macro Theory . Modern version: New-Keynesian . - John Maynard Keynes idea (1930s): Frictions in price and wage adjustment. => Aggregate demand for goods determines real output and real interest rates. => Money has a Liquidity Effect: influences aggregate demand => real variables. - Neoclassical version (1960s): Prices/wages eventually adjust. Long run = Classical. - Connect short run to long run via price adjustment process. - Major shortcoming: Supply of goods assumed constant or growing smoothly. - Optional for further readings: Sections of Mishkin ch.19-25. Required: Lecture note. [Note on Monetarism : Mostly a Keynesian view with simplified money demand function.] • Classical Macro Theory . Modern version: Real Business Cycles . - Real output determined by production (=Classical). Economic fluctuations due to technical innovations, tax incentives, raw material prices, etc. (1980s) - Economic fluctuations are not primarily driven by aggregate demand. Agenda: Examine classical & Keynesian theories separately. Then combine. - Output and interest rates fluctuate for many reasons (demand and supply shocks). - Challenge for monetary policy: Avoid inflation in a world with many disturbances!
3 [Classical Monetary Theory - P.3] Part 2: Macroeconomics in a Classical Economy • Assume classical setting: Focus on real activity. Money plays no essential role. • Essential elements of the economy: - Production function : Capital & labor => Output Y = Y s . Solow model: Y s is growing. [Extension with interest-sensitive labor supply => Y s (i r ) with positive slope; disregard.] - Labor market : Demand & supply => Real wage. - Goods market : - Real demand is interest-sensitive: I(i r ) and Y d (i r ) have negative slope - Real interest rate equates Y d (i r ) to Y s . Equilibrium output Y s =Y n .

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slides06 - 1 Money Prices and Inflation Part 1 Introduction...

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