Money Supply, Inflation, and Unemployment

The Equation of Exchange MV = PY So… %ΔM + %ΔV ≅ %ΔP + %ΔY M = Money Supply M = Money Supply V = Money Velocity V = Money Velocity P = Price Level P = Price Level Y = real GDP Y = real GDP

Inflation Rate in Long Run Since Velocity tends to remain culturally constant, %ΔM + 0 ≅ %ΔP + %ΔY Or %ΔM ≅ %ΔP + %ΔY Or, to understand inflation… %ΔP ≅ %ΔM — %ΔY M = Money Supply M = Money Supply V = Money Velocity V = Money Velocity P = Price Level P = Price Level Y = real GDP Y = real GDP

LRAS and Inflation This explains why the European Central Bank focuses their analysis on money supply This explains why the European Central Bank focuses their analysis on money supply If rGDP grows by 2 or 3% per year, then %ΔM reliably determines inflation If rGDP grows by 2 or 3% per year, then %ΔM reliably determines inflation %ΔP ≅ %ΔM — %ΔY %ΔP ≅ %ΔM — 3% M = Money Supply M = Money Supply V = Money Velocity V = Money Velocity P = Price Level P = Price Level Y = real GDP Y = real GDP

Unemployment: Reservation Wage Employees want the highest wage possible Employers generally want to pay the least required (but not always) As time unemployed lengthens, employees are willing to take lower wages, but are likely to find higher wage possibilities

US Unemployment Rate

Unemployment: Reservation Wage Government policy can affect wages and unemployment duration Welfare and unemployment relief payments extend duration Effect on wages and duration? RW 1 RW 2 Wage Duration of Search BOR

Unemployment: Reservation Wage Faster and more complete spread of information can lead to higher BoR Monster.com and other Internet sites increase job vacancy awareness Effect on wages and duration? RW 2 Wage Duration of Search BOR 1 BOR 2

Unemployment: Reservation Wage What is the effect of the comb- ination of unemployment payment policy and increased spread of information? Effect on wages and duration? RW 2 Wage Duration of Search BOR 2 BOR 1 RW 1

Scenario 1 The government, faced with rising budget deficits, decides to limit unemployment payments to only 4 weeks. What is the effect on output, rGDP, and Price Level? (Use which graph?) What is the likely effect on wages and the typical duration of search for a worker?

Scenario 2 ECB statistics show that the money supply is increasing by 8%. rGDP is increasing by 3%. What is the expected inflation rate? What monetary policy should the ECB take to redress the situation? What effect will this policy have on the value of the US dollar relative to the euro?