1. Discussion Question
Last year, the Federal Reserve engaged in open-market operations to the tune of 600 billion dollars. The discount rate and federal funds rates are at all time lows. Based on the quantity theory of money, this is sure to cause inflation. In 2009, we experienced the atypical scenario of deflation. With a group of 4, create a consensus for the following:
How can deflation seem good for the consumer but harmful to the economy as a whole?
How can inflation seem harmful to the consumer while at the same time be good for the economy as a whole?

2. Chapter 30 - Money Growth and Inflation
Inflation indicators:
Consumer Price Index (CPI)
GDP Deflator
How do we analyze the price level?
Inflation, disinflation, deflation, hyperinflation,
3 Theories:
Quantity Theory, Demand-Pull, Cost-Push
Chapter 30 - Money Growth and Inflation

4. Chapter 30 - Money Growth and Inflation
Readdress the effects of Inflation:
Inflation lowers value of money
Each dollar buys a smaller quantity of goods and services
Negatively affects people:
On a fixed income
Without a COLA in their contract
Banks that have offered fixed rates of interest
People that are unaffected/helped:
On a flexible income
With a COLA in their contract
Borrowers that have borrowed at fixed rates of interest
Chapter 30 - Money Growth and Inflation

5. What does a Lack of Inflation Indicate?
Growth
Borrowing
Spending
Expansion

6. What Can The Fed Do To Boost The Economy?
Expansionary Monetary Policy:
Buy Bonds
Lower interest rates
Increase borrowing
Create inflation (increase in price levels)

7. Effects of Low Interest Rates
Generally, low interest rates stimulate the economy because the cost of credit is low.
Consumers buy cars and houses.
Businesses expand, invest in capital, etc.
Impact of Lowering Rates:
The cost of borrowing money goes down.
Induced consumer spending increases economic activity.
Low interest rates cut the cost of capital for businesses and improve profit margins and encourages expansion.

8. What does Too Much Inflation Indicate?
Large Money Supply
Speculative Bubbles
Over Zealous Growth
Irrationality in the Market
Too much borrowing and spending

9. How can the fed slow the economy?
The Fed raises interest rates as an effective way to fight inflation.
Consumers pay more to borrow money, dampening spending.
Businesses have difficulty borrowing; unemployment rises.
The Fed generally raises rates as an effective way to quell inflation (a sustained rise in the general price level).
Inflation means that your money is worth less
Impact of Raising Rates:
Businesses have difficulty in obtaining loans for expansion; unemployment rises
Consumers will pay higher interest rates on credit cards and mortgages, which can cool spending.

10. Money Market Graph
Nominal Interest Rate
Interest Rates are high, qd of money is low because people prefer to have their money in a financial assett (bonds, cds, savings,etc.)
Interest rates are low, there is little incentive to save; people prefer to have their money on hand for spending
20% 5% 1%
D (Demand for Money)
Quantity of Money

11. Money Market Graph Who controls the money supply? The FED!
Nominal Interest Rate
S (Supply of Money)
Who controls the money supply?
The FED!
The supply curve is perfectly inelastic because the supply of money is not controlled by the interest rate
20% 5% 1%
4 Trillion
Quantity of Money

12. Money Market Graph
Nominal Interest Rate S2
S of Money S1
Increase money supply, decrease interest rates (easy money policy, expansionary monetary policy, ramp up borrowing and spending, price levels rise, S1)
Decrease money supply, increase interest rates (tight money policy, contractionary monetary policy, slow down borrowing and increase saving, price levels fall, s2)
How do they do this?
OMOs
RRR
DR/FFR
20% 5% 1%
Quantity of Money
4 Trillion

14. Monetary Policy 3 FED Tools Increase Money Supply
Decrease Money Supply
Open Market Operations
Reserve Requirements
Discount Rate/Fed Funds Rate
Buy
(Easy Money)
Sell
(Tight Money)

16. Contractionary Monetary Policy
+$50 Million
-$50 Million

17. MM = 1/RRR
1/.10 = 10
10 x 50 = 500 Million

19. Fixed Income1 year contract

20. The Effects of a Monetary Injection
What happens if the Fed doubles the supply of money by through open-market operations?
Quantity Theory of Money – the quantity of money available in the economy determines the value of money and inflation
New equilibrium
Supply curve shifts right
Interest Rates will fall
Price levels increase

21. a brief look at the adjustment process
Immediate effect of a monetary injection
Creates an excess supply of money
QS>QD of money
People will want to spend excess money
Increase in demand for goods and services
Ultimately, price of goods and services increases as a result of too much money chasing too little amount of goods
Increase in price level (CPI/GDP Deflator)

22. Too Much Money Video

24. The classical dichotomy & monetary neutrality
Classical dichotomy – division into two groups; division between the real side of the economy and the monetary side.
Theoretical separation of nominal & real variables
Nominal variables – variables measured in monetary units (not accounting for inflation)
Real variables – variables measured in physical units (accounting for inflation)
GDP, Interest Rates, Income, etc.

25. Nominal and Real Variables= =
How does this affect consumers?
Reduced purchasing power
Interest rates on money in the bank must keep up with the 100% increase in price levels

26. The classical dichotomy & monetary neutrality
Monetary neutrality – changes in money supply don’t affect real variables in the long run, only nominal variables in the long run
Long run, nominal variables adjust to match expected inflation
Short run – less than 2 years
Long run – greater than 2 years

27. Velocity and the quantity equation
Velocity of money (V)
Average number of times a dollar is used to purchase a final product during a year
Speed at which a dollar bill travels from wallet to wallet
How many times is a dollar bill used to pay for a newly produced good or service?
Used to determine the growth of the economy and bank lending
Slow velocity means slow spending, slow lending

28. Velocity and the quantity equation
Quantity Equation – shows that money supply has a direct, proportional relationship with the price level.
Quantity equation: M × V = P × Y
Quantity of money (M)
Velocity of money (V)
Price Level (P)
GDP (Y)
Classical economists believed that velocity (V) of money was constant, virtually unchanging
Real GDP (Y) was unchanged by increases in quantity of money
Increases in money supply (m) would lead to proportional increases in price level (P)

29. Velocity of Money
Economy has $
+$500
+$700.00
+$200.00
+$300.00
+$300
$ $300 + $700 + $200 + $300 = $2000

30. $ $300 + $700 + $200 + $300 = $2000
V = Price x GDP(Nominal)/MS
V = $400 x 5/1000
V = $2000/1000
V = 2
Quantity Equation
M x V = P x Y
1000 x 2 = $400 x 5
2000 = 2000
Monetary Neutrality
$10,000 x 2 = $2000 x 5

31. The Inflation Tax
How does government cause countries experience inflation?
Government Revenue
Taxation – levying taxes, income, sales, excise, property, etc.
Borrowing – selling of bonds
Printing of money
Inflation tax – the revenue the government raises by creating money
No one receives a bill for this tax
Increase in price levels, dollars are less valuable
Tax burden is on everyone that holds money
U.S. – 3% inflation
November 2008 estimated Zimbabwe's annual inflation rate at 89.7 sextillion (1021) percent. By December 2008, annual inflation was estimated at 6.5 quindecillion novemdecillion percent (6.5 x 10108%, the equivalent of 6 quinquatrigintillion 500 quattuortrigintillion percent, or 65 followed by 107 zeros – one googol 65 million percent).

32. Fisher Effect
Real interest rate = Nominal interest rate – Inflation rate
Bank posts nominal interest rate of 7% per year and inflation is 3%, real interest rate is 4% per year
Nominal interest rate = Real interest rate + Inflation rate
Fisher effect – developed by Irving Fisher, one-for-one long-run adjustment of nominal interest rate to inflation rate
Nominal interest rate adjusts to expected inflation

33. Nominal Interest rate is 8%
Fisher Effect
Nominal Interest rate is 8%
Inflation is 3%
Real Interest Rate = 8% - 3%
r = 5%
Inflation is 8%
Real Interest Rate = 8%-8%
r = 0

34. Unanticipated Inflation
Problems arise when there is unanticipated inflation:
Creditors (lenders) lose and borrowers gain if the lender does not anticipate inflation correctly.
For those who borrow, this is similar to getting an interest-free loan.
When the Fed increases the rate of money growth
Higher inflation rate
Higher price levels

35. Is Inflation a Problem? Costs of Inflation (real variables)
Shoeleather costs
Resources wasted when inflation encourages people to reduce their money holdings
More frequent trips to the bank cause your shoes to wear out

36. Is Inflation a Problem? Menu costs Costs of changing prices
Inflation – increases input costs that firms must bear

37. Is Inflation a Problem?
Relative-price variability & misallocation of resources
Inflation distorts relative prices, consumer and firms decisions become distorted
Markets are not as efficient when they can’t predict inflation

38. Is Inflation a Problem? Inflation induced tax distortion
Consumer decisions – stop saving
Markets – less able to set contracts/loans, to their best use

39. Why Is Inflation a Problem?
Confusion and inconvenience
Money is the yardstick with which we measure economic transactions
The Fed’s job is to ensure the reliability of money
When the Fed increases the money supply, creates inflation
Erodes the real value of the unit of account, which can cause confusion

40. Why Is Inflation a Problem
Costs of Inflation:
Unexpected inflation
Redistributes wealth among the population
Redistribute wealth among borrowers and lenders

42. Flow Chart – Costs of Inflation, pgs. 677 - 682
Shoeleather Costs
Menu Costs
Relative-Price Variability and the Missallocation of Resources
Inflation-Induced Tax Distortions
Confusion and Inconvenience
A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth
Description - Avoiding inflation
- Definition - Bolivia Example (briefly describe)
Description - Firm price changes
- Definition
- Effect of Inflation
Description - Eatabit Eatery example
- Relative prices and Consumption decisions
Description - Discourage saving (capital gains)
- Microsoft example
- Tax treatment of nominal interest
- Solution to the problem
Description
- Yardstick Metaphor
- Increase in Money Supply
- Confusion as a result of inflation
Description
- Unexpected inflation
- Sam Student example
- Predictable vs. unpredictable inflation
- Cost of unexpected inflation

43. Mankiw Practice Chapter 29 Mankiw Practice Chapter 30 Free Responses
Due Wednesday
Chapter 30 
Mankiw Practice Chapter 29
Mankiw Practice Chapter 30
Free Responses
Daily Tens
Notes Chapter 30
Terms

44. Formulas V = (P × Y)/M Quantity equation: M × V = P × Y
Real Interest Rate = Nominal interest rate – Inflation rate
Nominal interest rate = Real interest rate + Inflation rate
Political Cartoon:
What do you think the event(s) or issue(s) are that inspired the cartoon? What is the cartoonist trying to portray in the cartoon?
Are there any real people/places in the cartoon? Who are these people?
Are there symbols in the cartoon? What are they and what do they represent?
What is your opinion of the cartoon, do you agree or disagree? Why?

45. Formulas
Last year, the Federal Reserve engaged in open-market operations to the tune of 600 billion dollars. As a result, the federal funds rate are at all time lows. Based on the quantity theory of money, this is sure to cause inflation. Why would the Fed want to create inflation in the economy?
What should the FED do if the economy begins to expand beyond what is normal inflation? What type of monetary policy is this referred to as?
Describe the three theories of inflation.
Political Cartoon:
What do you think the event(s) or issue(s) are that inspired the cartoon? What is the cartoonist trying to portray in the cartoon?
Are there any real people/places in the cartoon? Who are these people?
Are there symbols in the cartoon? What are they and what do they represent?

46. Chapter 30 – Application Questions
Why do people hold money?
How will an increase in the interest rate on bonds influence the amount of money that people will want to hold?
How would each of the following influence the quantity of money you would like to hold?
An increase in the interest rate on checking deposits
An increase in the expected rate of inflation
An increase in income
Use the quantity equation for this problem. Suppose the money supply is $200, real output is 1,000 units, and the price per unit of output is $1.
What is the value of velocity?
If velocity is fixed at the value you solved for in part (a), what does the quantity theory of money suggest will happen if the money supply is increased to $400?
Is your answer in part (b) consistent with the classical dichotomy? Explain.
When inflation gets very high, people do not like to hold money because it is losing value quickly. Therefore, they spend it faster. If, when the money supply is doubled, people spend money more quickly, what happens to prices? Do prices more than double, less than double, or exactly double? Why?
Suppose the money supply at the beginning of this problem refers to M1. That is, the M1 money supply is $200. What would the M2 quantity equation look like if the M2 money supply were $500 (and all other values were as stated at the beginning of the problem)?

47. Chapter 30 - Daily Assignment Questions
Why do people hold money? People - buy things, groceries, house payment, gas, prepare for accidents or medical emergencys, etc. Businesses – pay their workers, buy supplies.
How will an increase in the interest rate on bonds influence the amount of money that people will want to hold? Interest rates make it more costly to hold money. $1000, 10% interest, it would cost you $100 a year. If it is 1%, the cost of holding your money is only $10.
How would each of the following influence the quantity of money you would like to hold?
An increase in the interest rate on checking deposits - Increase incentive to hold your money deposits
An increase in the expected rate of inflation - Reduce your incentive to hold money
An increase in income - Increase your incentive to hold money for consumption purposes

48. Chapter 30 - Daily Assignment Questions
Use the quantity equation for this problem. Suppose the money supply is $200, real output is 1,000 units, and the price per unit of output is $1.
What is the value of velocity? V = (1,000 x $1)/$200 = 5
If velocity is fixed at the value you solved for in part (a), what does the quantity theory of money suggest will happen if the money supply is increased to $400? $400 x 5 = $2 x 1,000, prices will double from $1 to $2
Is your answer in part (b) consistent with the classical dichotomy? Explain. Yes. The classical dichotomy divides economic variables into real and nominal. According to classical economists money affects nominal variables proportionately and has no impact on real variables. In part (b), prices double, but real output remains constant.
When inflation gets very high, people do not like to hold money because it is losing value quickly. Therefore, they spend it faster. If, when the money supply is doubled, people spend money more quickly, what happens to prices? Do prices more than double, less than double, or exactly double? Why? Money has a proportional impact on nominal output if V is constant If V grows, a doubling of M will cause P to more than double.
Suppose the money supply at the beginning of this problem refers to M1. That is, the M1 money supply is $200. What would the M2 quantity equation look like if the M2 money supply were $500 (and all other values were as stated at the beginning of the problem)?
$500 x 2 = $1 x 1,000, M2 velocity is 2.

49. Money Market Graph The FED Reserve buys government securities
The FED sells government securities
The FED lowers the RRR
The FED Raises the RRR
Group 5 – Velocity and the Quantity Equation Velocity of money, formula, math example, quantity equation
Group 6 – Five Steps of the Quantity Theory of Money List five steps (pg. 672)