Ch. 14, Macroeconomics, R.A. Arnold Money and the Economy Ch. 14, Macroeconomics, R.A. Arnold

Prologue In Ch. 12 we defined the Money Supply (includes paper money, coins, deposits in banks). The Central Bank of an economy controls the money supply of the economy. They can change the money supply to affect the price level and the interest rate in the economy to achieve macroeconomic goals which is called Monetary Policy. This chapter explains how a change in money supply may affect the price level and interest rate in the economy.

The Equation of Exchange 𝑀𝑉≡𝑃𝑄 where, M: Money supply, V: Velocity, P: Price Level, Q: Total quantity of goods and services in the economy Velocity: Average number of times a dollar is spent (or changes hand) to buy final goods and services In the equation of exchange, Total spending or expenditures (TE) is measured by 𝑀𝑉 Total sales revenues of business firms and nominal GDP, is measured by PQ

The Simple Quantity Theory of Money We can use the equation of exchange to derive the simple quantity theory of money which states that ‘assuming velocity (V) and Real GDP (Q) are constant then changes in money supply (M) will bring about strictly proportional changes in price level (P).’ – Classical Economists Applying the theory in the AD-AS Framework We know, MV = TE = C + I + G + NX … at a given (fixed) price level, if M changes then C, I G, NX changes and hence AD changes (ch. 8). If M increases AD (increases) shifts right and if M decreases AD (decreases) shifts left. Since, Q (Real GDP) is constant in the short run, the aggregate supply curve is vertical. Figure Next Slide. As you can see in Figure as M increases (decreases) AD shifts right (left) and increases (decreases) the price level…as predicted by the quantity theory of money.

Monetarism Monetarists do not believe that velocity and output is constant. Their assumptions about the economy - the four monetarist positions – are as follows: 1) Velocity changes in a predictable way and it is a function of (i.e. depends upon) the interest rate, the expected inflation rate, the frequency with which employees receive pay-check and many more… 2) Aggregate demand depends on money supply and on velocity (since, MV = TE = C + I + G + NX…relate to information in last slide) 3) SRAS curve is upward sloping (according to monetarists Real GDP may change in the short-run) 4) The economy is self-regulating (prices and wages are flexible)

Monetarism and AD-AS Four cases have been illustrated in Figure Next Slide. In all cases, the economy is initially assumed to be in the long-run (LR) equilibrium… M increases (assuming ceteris paribus), AD increases (shifts right) and economy enters into a inflationary gap (real GDP > natural real GDP and U < UN ). The shortage in the labour market increases the wage rate and hence the SRAS shifts left and the economy self-regulates itself back to the LR equilibrium producing same level of output as it originally did but at a higher price level. M decreases (assuming ceteris paribus), AD decreases (shifts left) and economy enters a recessionary gap (real GDP < natural real GDP and U > UN ). The surplus in the labour market decreases the wage rate and hence the SRAS shifts right and the economy self regulates itself back to the LR equilibrium producing the same level of output as it originally did but at a lower price level

Continued c) When V increases (assuming ceteris paribus), AD shifts right and economy enters a inflationary gap…the rest of the analysis is the same as that of (a) d) When V decreases (assuming ceteris paribus), AD shifts left and economy enters a recessionary gap…the rest of the analysis is the same as that of (b) Summary: An increase in money supply will raise aggregate demand, increase real GDP and price level in the short-run, and increase only the price level in the long-run. A decrease in M will lower AD, decrease both Real GDP and the price level in the short-run, and decrease only the price level in the long-run.

Money and Interest Rates So far we have seen change in money supply affects price level and Real GDP in the short run. Here we study how these may affect the interest rate (in the loanable funds market; figure last slide): 1) If the central bank expands (increases) the money supply then the supply of loanable funds increases (since reserves of banks increase and they loan out the excess reserves). This causes the interest rate in the loanable funds market to go down. A change in the interest rate due to a change in the supply of loanable funds is the liquidity effect. Figure (a)

(2) Real GDP. Figure (c) When real GDP rises people’s wealth increases (goods are a component of wealth) and they demand more bonds (i.e. they are willing to supply more loanable funds). On the other hand, rising GDP encourages firms to invest more and hence they supply more bonds (i.e. demand more loanable funds). We assume, that the demand for loanable funds increase more than the supply of loanable funds hence the interest rate rises. This change in the interest rate due to a change in the Real GDP is the income effect. (3) The price-level effect. Figure (d) When the price level increases the purchasing power of money falls, and households may increase their demand for credit or loanable funds to buy a fixed bundle of goods, hence the interest rate increases. A change in the interest rate due to a change in the price level is the price-level effect.