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Chapter 11 Money Growth and inflation

Chapter 11 Money Growth and inflation - Chapter XI Money...

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Chapter XI Money Growth and inflation In this chapter, look for the answers to these questions: How does the money supply affect inflation and nominal interest rates? Does the money supply affect real variables like real GDP or the real interest rate? How is inflation like a tax? What are the costs of inflation? How serious are they? Introduction This chapter introduces the quantity theory of money to explain one of the Ten Principles of Economics from Chapter 1: Prices rise when the Government prints too much money. Most economists believe the quantity theory is a good explanation of the long run behaviour of inflation. The Classical Theory of Inflation *classical means long run Inflation is an increase in the overall level of prices. Hyperinflation is an extraordinarily high rate of inflation. Inflation: Historical Aspects i. Over the past 60 years, prices have risen on average about 4 percent per year. ii. Deflation, meaning decreasing average prices, occurred in Canada in the twentieth century. iii. Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s. iv. In the 1970s prices rose by 7 percent per year. v. During the 1990s, prices rose at an average rate of 2 percent per year. The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate. Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange. When the overall price level rises, the value of money falls. The Value of Money P = the price level ( e.g. , the CPI or GDP deflator) P is the price of a basket of goods, measured in money. 1/ P is the value of $1, measured in goods. Example: basket contains one candy bar. If P = $2, value of $1 is 1/2 candy bar If P = $3, value of $1 is 1/3 candy bar Inflation drives up prices and drives down the value of money.
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The Quantity Theory of Money Developed by 18 th century philosopher David Hume and the classical economists Advocated more recently by Nobel Prize Laureate Milton Friedman Asserts that the quantity of money determines the value of money We study this theory using two approaches: 1. A supply-demand diagram 2. An equation a) Money Supply (MS) In real world, determined by the Bank of Canada (BoC), the banking system, consumers. In this model, we assume the BoC precisely controls MS and sets it at some fixed amount. b) Money Demand (MD) Refers to how much wealth people want to hold in liquid form. Depends on P : An increase in P reduces the value of money, so more money is required to buy goods and services. Thus, quantity of money demanded is negatively related to the value of money and positively related to P , other things equal.
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