11b Money and Inflation

General Information 24.10. Introduction; Transformation Curve, Opportunity Cost Mankiw ch.1,2 31.10. Markets: Demand and Supply Ch. 4 7.11. Elasticities Ch. 5 14.11. Costs, Production Function Ch. 13 21.11. Markets with perfect competiton Ch. 7, 14 28.11. Taxation Ch. 8 5.12. International Trade Ch. 9 12.12. Imperfect competition: Monopoly, and Oligoploy Ch. 15, 16 19.12. Public Goods, Externalities Ch. 10,11 9.1. National Accounting, Gross Domestic Product, Growth Ch. 23, 25 16.1. Money and Inflation Ch. 24, 29, 30 23.1. Business Cycles Ch. 33, 34 30.1. Open Economy Macro Ch. 31

The Classical Dichotomy and Monetary Neutrality According to Hume and others, real economic variables do not change with changes in the money supply. According to the classical dichotomy, different forces influence real and nominal variables. Changes in the money supply affect nominal variables but not real variables. The irrelevance of monetary changes for real variables is called monetary neutrality.

Velocity and the Quantity Equation The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. V = (P  Y)/M Where: V = velocity Y = quantity of output P = price level M = quantity of money http://www.wheresgeorge.com/ (US) http://www.eurobilltracker.com/ (euro area) http://www.cashfollow.ch/ (CH)

Velocity and the Quantity Equation Rewriting the equation gives the quantity equation: M  V = P  Y The quantity equation relates the quantity of money (M) to the nominal value of output (P  Y).

Velocity and the Quantity Equation The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall.

International data on inflation and money growth

U.S. data on inflation and money growth

Velocity and the Quantity Equation The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money The velocity of money is relatively stable over time. When the SNB changes the quantity of money, it causes proportionate changes in the nominal value of output (P  Y). Because money is neutral, money does not affect output.

THE COSTS OF INFLATION A Fall in Purchasing Power? Inflation does not in itself reduce people’s real purchasing power. The costs of inflation Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth

12 Business Cycles

Short-Run Economic Fluctuations Economic activity fluctuates from year to year. In most years production of goods and services rises. On average over the past 50 years, production in the U.S. economy has grown by about 3 percent per year. In some years normal growth does not occur, causing a recession.

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Economic fluctuations are irregular and unpredictable. Fluctuations in the economy are often called the business cycle. Most macroeconomic variables fluctuate together. As output falls, unemployment rises.

Swiss GDP per capita (in 2002 US$, PPP) Quelle: GGDC, eigene Berechnungen Konvergenz-Hypothese. The oil price increase resulted in a rise in unemployment. Lacking unemployment insurance, foreign workers returned to their home countries, or they had to leave because their residence and work permits were not prolonged. As a result, the resident population fell by nearly 150,000 – or 2.2% from 1974 to 1977.

Swiss GDP and KOF-Barometer Y-to-Y in % BFS: SNA 09/2006, Quartalisation: seco -1 1 2 3 4 5 -0.6 0.0 0.6 1.2 1.8 2.4 3.0 KOF-Barometer 1999 2000 2001 2002 2003 2004 2005 2006 2007

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Most macroeconomic variables fluctuate together. Most macroeconomic variables that measure some type of income or production fluctuate closely together. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

BFS: SNA 09/2006, Quartalisation: seco Swiss exports: Y-to-Y in % Billion. Fr. (Quarter) BFS: SNA 09/2006, Quartalisation: seco KOF-Forecast 10/2006 -8 -4 4 8 12 16 40 44 48 52 56 60 64 7.0% 2.7% 3.3% 2003 2004 2005 2006 2007 2008

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS As output falls, unemployment rises. Changes in real GDP are inversely related to changes in the unemployment rate. During times of recession, unemployment rises substantially.

Employment vs. GDP (in Switzerland) 2.0 1.0 Employment -1.0 -2.0 -3.0 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 Real GDP growth (2-years average) Quelle: BFS und KOF

EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS How the Short Run Differs from the Long Run Most economists believe that classical theory describes the world in the long run but not in the short run. Changes in the money supply affect nominal variables but not real variables in the long run. The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy.

The Basic Model of Economic Fluctuations Two variables are used to develop a model to analyze the short-run fluctuations. The economy’s output of goods and services measured by real GDP. The overall price level measured by the CPI or the GDP deflator.

The Basic Model of Economic Fluctuations The Basic Model of Aggregate Demand and Aggregate Supply Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

The Basic Model of Economic Fluctuations The Basic Model of Aggregate Demand and Aggregate Supply The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

The Basic Model of Economic Fluctuations The Basic Model of Aggregate Demand and Aggregate Supply The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

Figure 2 Aggregate Demand and Aggregate Supply... Price Level Aggregate supply Aggregate demand Equilibrium output price level Quantity of Output

THE AGGREGATE-DEMAND CURVE The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

Figure 3 The Aggregate-Demand Curve... Price Level Aggregate demand P Y 1. A decrease in the price level . . . Y2 P2 Quantity of 2. . . . increases the quantity of goods and services demanded. Output

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Consumption: The Wealth Effect The Price Level and Investment: The Interest Rate Effect The Price Level and Net Exports: The Exchange-Rate Effect

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Consumption: The Wealth Effect A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Investment: The Interest Rate Effect A lower price level reduces the interest rate, which encourages greater spending on investment goods. This increase in investment spending means a larger quantity of goods and services demanded.

Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Net Exports: The Exchange-Rate Effect When a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, which stimulates U.S. net exports. The increase in net export spending means a larger quantity of goods and services demanded.

Why the Aggregate-Demand Curve Might Shift The downward slope of the aggregate demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other factors, however, affect the quantity of goods and services demanded at any given price level. When one of these other factors changes, the aggregate demand curve shifts.

Why the Aggregate-Demand Curve Might Shift Shifts arising from Consumption Investment Government Purchases Net Exports

Shifts in the Aggregate Demand Curve Price Level D2 P1 Y2 Remove bullet in graph – graph needs no additional title??? Aggregate demand, D1 Y1 Quantity of Output

THE AGGREGATE-SUPPLY CURVE In the long run, the aggregate-supply curve is vertical. In the short run, the aggregate-supply curve is upward sloping.

THE AGGREGATE-SUPPLY CURVE The Long-Run Aggregate-Supply Curve In the long run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. The price level does not affect these variables in the long run.

Figure 4 The Long-Run Aggregate-Supply Curve Price Level Long-run aggregate supply P 1. A change in the price level . . . P2 2. . . . does not affect the quantity of goods and services supplied in the long run. Natural rate Quantity of of output Output

THE AGGREGATE-SUPPLY CURVE The Long-Run Aggregate-Supply Curve The long-run aggregate-supply curve is vertical at the natural rate of output. This level of production is also referred to as potential output or full-employment output.

Why the Long-Run Aggregate-Supply Curve Might Shift Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. The shifts may be categorized according to the various factors in the classical model that affect output.

Why the Long-Run Aggregate-Supply Curve Might Shift Shifts arising Labor Capital Natural Resources Technological Knowledge

Figure 5 Long-Run Growth and Inflation 2. . . . and growth in the money supply shifts aggregate demand . . . Long-run aggregate supply, LRAS 1980 Y 1990 LRAS Y 2000 LRAS Price Aggregate Demand, AD 2000 Level 1. In the long run, technological progress shifts long-run aggregate supply . . . AD 1990 P 2000 4. . . . and ongoing inflation. P 1990 P 1980 AD 1980 Y 1980 3. . . . leading to growth in output . . . Quantity of Output

A New Way to Depict Long-Run Growth and Inflation Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

Figure 6 The Short-Run Aggregate-Supply Curve Price Level Short-run aggregate supply Y P 1. A decrease in the price level . . . Y2 P2 2. . . . reduces the quantity of goods and services supplied in the short run. Quantity of Output

Why the Aggregate-Supply Curve Slopes Upward in the Short Run The Misperceptions Theory The Sticky-Wage Theory The Sticky-Price Theory The order of discussion in Mankiw has been changed. The “misperceptions theory” must be moved to the bottom of the list. (This may affect the entire order of presentation following this slide.)

Why the Aggregate-Supply Curve Slopes Upward in the Short Run The Misperceptions Theory Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output: A lower price level causes misperceptions about relative prices. These misperceptions induce suppliers to decrease the quantity of goods and services supplied. Move this slide so that it follows the next two slides. That puts the discussion in the new order of the text.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run The Sticky-Wage Theory Nominal wages are slow to adjust, or are “sticky” in the short run: Wages do not adjust immediately to a fall in the price level. A lower price level makes employment and production less profitable. This induces firms to reduce the quantity of goods and services supplied.

The Sticky-Price Theory Prices of some goods and services adjust sluggishly in response to changing economic conditions: An unexpected fall in the price level leaves some firms with higher-than-desired prices. This depresses sales, which induces firms to reduce the quantity of goods and services they produce. For consistency, title this slide, “Why the Aggregate supply curves slopes upward in the short run” like the previous two slides. Then move “The sticky-price theory” in large print to the top bullet (like the previous two slides).

Why the Short-Run Aggregate-Supply Curve Might Shift Shifts arising Labor Capital Natural Resources Technology Expected Price Level

Why the Aggregate Supply Curve Might Shift An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the right. Should title be, “Why the short-run aggregate supply…”

Figure 7 The Long-Run Equilibrium Price Level Long-run aggregate supply Short-run aggregate supply Aggregate demand A Equilibrium price Natural rate of output Quantity of Output

Figure 8 A Contraction in Aggregate Demand 2. . . . causes output to fall in the short run . . . Price Level Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD AS2 AD2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . A P Y B P2 Y2 1. A decrease in aggregate demand . . . C P3 4. . . . and output returns to its natural rate. Quantity of Output

TWO CAUSES OF ECONOMIC FLUCTUATIONS Shifts in Aggregate Demand In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

TWO CAUSES OF ECONOMIC FLUCTUATIONS An Adverse Shift in Aggregate Supply A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of employment. Unemployment rises. The price level rises.

Figure 10 An Adverse Shift in Aggregate Supply 1. An adverse shift in the short- run aggregate-supply curve . . . Price Level Long-run Short-run aggregate supply, AS AS2 aggregate supply Aggregate demand B Y2 P2 Y A P 3. . . . and the price level to rise. Quantity of 2. . . . causes output to fall . . . Output

The Effects of a Shift in Aggregate Supply Stagflation Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

The Effects of a Shift in Aggregate Supply Policy Responses to Recession Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy.

Figure 11 Accommodating an Adverse Shift in Aggregate Supply 1. When short-run aggregate supply falls . . . Price Level Long-run Short-run aggregate supply, AS AS2 aggregate AD2 supply C P3 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . 3. . . . which causes the price level to rise further . . . P2 A P 4. . . . but keeps output at its natural rate. Aggregate demand, AD Natural rate Quantity of of output Output

Summary All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.

Summary Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. According to the model of aggregate demand and aggregate supply, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.

Summary The aggregate-demand curve slopes downward for three reasons: a wealth effect, an interest rate effect, and an exchange rate effect. Any event or policy that changes consumption, investment, government purchases, or net exports at a given price level will shift the aggregate-demand curve.

Summary In the long run, the aggregate supply curve is vertical. The short-run, the aggregate supply curve is upward sloping. The are three theories explaining the upward slope of short-run aggregate supply: the misperceptions theory, the sticky-wage theory, and the sticky-price theory. Bullet three, move the misperceptions theory to the end.

Summary Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve. Also, the position of the short-run aggregate-supply curve depends on the expected price level. One possible cause of economic fluctuations is a shift in aggregate demand.

Summary A second possible cause of economic fluctuations is a shift in aggregate supply. Stagflation is a period of falling output and rising prices.