# C HAPTER 14 M ONEY AND THE E CONOMY. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible.

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C HAPTER 14 M ONEY AND THE E CONOMY

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A DMINISTRATIVE D ETAILS The second exam will be next week, Thursday 19 th. The second exam will cover Chapters 10-14. 13-2

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. M ONEY AND THE P RICE L EVEL T HE C LASSICAL V IEW Classical economists believed that changes in the money supply affect the price level in the economy, but not the level of output, i.e. monetary policy cannot be used to affect real GDP and employment. This view is still held by many economists including Milton Friedman and others. Based upon the Equation of Exchange which is an identity stating that the money supply times velocity* must be equal to the price level times Real GDP. M x V P x Q *The average number of times a dollar is spent to buy final goods and services in a year.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. E QUATION OF E XCHANGE M x V P x Q where: M represents Money Supply V represents Velocity* means must be equal to P represents Price Q represents Real GDP There is nothing profound about the Equation of Exchange because it is a simply mathematical identity like 2+2=4.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C ALCULATING V ELOCITY In a large economy such as ours, it is impossible to simply count how many times each dollar changes hands (velocity). As an alternative: M x V = P x Q Where: 1. GDP is equal to P x Q 2. M x V = GDP 3. V = GDP* / M*

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. E QUATION OF E XCHANGE - R EVISITED If: 1. M x V = Total Spending 2. P x Q = Total Sales Revenue of Business Firms (GDP) The Equation of Exchange simply says that the sum of everything bought (total spending) has to equal the sum of everything sold (total sales. Total Spending Total Sales Revenue of Business Firms

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. S IMPLE Q UANTITY T HEORY OF M ONEY The theory that assumes that velocity (V) and Real GDP (Q) are constant in the short run and predicts that changes in the money supply (M) lead to strictly proportional changes in the price level (P). M x V P x Q

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. R EAL GDP How much does Real GDP change from year to year?

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. VELOCITY

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. A SSUMPTIONS AND P REDICTIONS OF THE S IMPLE Q UANTITY T HEORY OF M ONEY The simple quantity theory of money assumes that both V and Q are constant. (A bar over each indicates this in the exhibit.) The prediction is that changes in M lead to strictly proportional changes in P. Think of Q as so many units of goods and of P as the average price paid per unit of these goods.)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. THE AD CURVE IN THE SIMPLE QUANTITY THEORY OF MONEY M x V = Total Expenditures (TE) TE = C + I + G + (X-M) M x V = C + I + G + (X-M) = Aggregate Demand (AD) Change in M and/or V will cause a change in AD

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Aggregate Demand in the Simple Quantity Theory of Money 1.AD with V constant (a) 2.RGDP fixed in short run (b) -the level of Real GDP is assumed to be constant in the short run 3.M increases/decreases (c) causing AD to shift

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. V ELOCITY AND R EAL GDP V ARIABLE If we drop the assumptions that velocity (V ) and Real GDP (Q) are constant, we have a more general theory of the factors that cause changes in the price level. In this theory, changes in the price level depend on three variables: 1. Money supply (M) 2. Velocity (V) 3. Real GDP (Q) M x V P x Q If the equation of exchange holds, then P M x V Q An increase in M and/or V and/or a decrease in Q will cause prices to rise.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. M ONETARISM IN A AD–AS F RAMEWORK I F : M ONEY S UPPLY I NCREASES M x V = C + I + G + (X-M) = Aggregate Demand (AD) You combine the Equation of Exchange and the AD/AS model by noting that M*V =AD. When there is an increase or decrease in M, AD correspondingly shifts to the right or left.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. M ONETARISM IN A AD–AS F RAMEWORK I F : M ONEY S UPPLY D ECREASES M x V = C + I + G + (X-M) = Aggregate Demand (AD) A decrease in the money supply (M) will cause a decrease in AD putting the economy into a recessionary gap where prices go down and real GDP decreases temporarily. Wages will fall and the AS will shift to the right moving the economy back to the LRAS.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. M ONETARISM IN A AD–AS F RAMEWORK I F : V ELOCITY I NCREASES An increase in velocity will cause AD to increase. This will increase prices and real GDP in the short run. In the long run, wages will increase leading to a leftward shift of the SRAS and returning the economy to the LRAS in the long run. M x V = C + I + G + (X-M) = Aggregate Demand (AD)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. M ONETARISM IN A AD–AS F RAMEWORK I F : V ELOCITY D ECREASES A decrease in velocity will cause AD to increase. This will decrease prices and real GDP in the short run. In the long run, wages will decrease leading to a rightward shift of the SRAS and returning the economy to the LRAS in the long run. M x V = C + I + G + (X-M) = Aggregate Demand (AD)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. M ONETARIST V IEW OF THE E CONOMY Monetarists believe: 1. The economy is self-regulating.Wages adjust to the market forces of supply and demand captured statistically by the unemployment rate. 2. Changes in velocity and the money supply can change aggregate demand in the short run. 3. Changes in velocity and the money supply will change the price level and Real GDP in the short run but only the price level in the long run.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. T WO A CTIVIST MONETARY P OLICIES One time increase in the money supply. Continually increasing money supply.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. I NFLATION I NCREASE IN THE P RICE L EVEL I One-Shot Inflation - A one-time increase in the price level caused by a one time increase in the money supply. An increase in the price level that does not continue.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. O NE -S HOT I NFLATION : D EMAND -S IDE, I NDUCED If monetary policy is a one-time increase in the money supply: In the short run: 1.The aggregate demand curve shifts rightward from AD1 to AD2. 2.As a result, the price level increases from P1 to P2. 3.The economy moves from point 1 to point 2. In the long run: 1.Wages will rise. 2.SRAS will shift to the left. M x V = C + I + G + (X-M) = Aggregate Demand (AD)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. O NE -S HOT I NFLATION : S UPPLY -S IDE I NDUCED I Inflation can be caused by a shift in SRAS instead of an increase in the money supply. 1. The short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2. 2. As a result, the price level increases from P1 to P2; the economy moves from point 1 to point 2. In the long run: 1. Because the Real GDP the economy produces (Q2) is less than Natural Real GDP, the unemployment rate that exists is greater than the natural unemployment rate. 2. Some economists argue that when this happens, wage rates will fall and the short- run aggregate supply curve will shift rightward from SRAS2 (back to SRAS1). 3. Long-run equilibrium is at point 1.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. I NFLATION I NCREASE IN THE P RICE L EVEL II Continued Inflation - A continued increase in the price level.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C ONTINUOUS I NFLATION I B EGINS WITH S HIFT IN AD 1. The aggregate demand curve shifts rightward from AD 1 to AD 2. 2. The economy initially moves from point 1to point 2 and finally to point 3. 3. Continued increases in the price level are brought about through continued increases in aggregate demand.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C ONTINUOUS I NFLATION II 1. The short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2. 2. The economy initially moves from point 1 to point 2. 3. The economy will return to point 1 unless there is an increase in aggregate demand. 4. We see here that continued increases in the price level are brought about through continued increases in aggregate demand.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. E CONOMIC V ARIABLES A FFECTED BY A C HANGE IN THE M ONEY S UPPLY When the FED engages in an activist monetary policy, i.e. constantly changing the money supply it affects: 1. The supply of loans 2. Real GDP 3. The price level, and 4. The expected inflation rate A Fed open market purchase increases reserves in the banking system and therefore increases the supply of loanable funds. As a result, the interest rate declines.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. T HE I NTEREST R ATE AND THE L OANABLE F UNDS M ARKET To supply bonds is to demand loanable funds. To demand bonds is to supply loanable funds

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. L IQUIDITY E FFECT The change in the interest rate due to a change in the supply of loanable funds. A Fed open market purchase increases reserves in the banking system and therefore increases the supply of loanable funds. As a result, the interest rate declines.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. I NCOME E FFECT I When real GDP increases, both the supply of and the demand for loanable funds increase.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. I NCOME E FFECT II The overall effect on the interest rate is that, usually, the demand for loanable funds increases by more than the supply so that the interest rate rises. The change in the interest rate due to a change in real GDP is called the income effect. Permanent Income Hypothesis-Temporary vs. permanent

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. P RICE L EVEL E FFECT When the price level rises, the purchasing power of money falls. People may therefore increase their demand for credit or loanable funds to borrow the funds necessary to buy a fixed bundle of goods. This change in the interest rate due to a change in the price level is called the price-level effect.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. E XPECTATIONS E FFECT I Borrowers (demanders of loanable funds) will be willing to pay more interest for their loans because they expect to be paying back the loans with dollars that have less buying power than the dollars they are borrowing. This will increase demand and reduce supply of loanable funds.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. E XPECTATIONS E FFECT II Lenders (the suppliers of loanable funds) require a higher interest rate to compensate them for the less valuable dollars with which the loan will be repaid. In effect, the supply of loanable funds curve shifts leftward. The change in the interest rate due to a change in the expected inflation rate.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. W HAT H APPENS TO THE I NTEREST R ATE AS THE M ONEY S UPPLY C HANGES ? Point 1 in time: Fed says it will increase the growth rate of the money supply. Note that the FED doesnt actually have to increase the money supply, it simply has to announce that it will and have people believe them. 1. Point 2 in time: If the expectations effect kicks in immediately, then... 2. Point 3 in time: Interest rates rise. 3. Point 4 in time: Liquidity effect kicks in. 4. Point 5 in time: As a result of what happened at point 4, the interest rate drops. 5. The interest rate is now lower than it was at point 3.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. W HAT H APPENS TO THE I NTEREST R ATE AS THE M ONEY S UPPLY C HANGES ? 1. A change in the money supply affects the economy in many ways. 2. Changing the supply of loanable funds directly, changing Real GDP and therefore changing the demand for and supply of loanable funds, changing the expected inflation rate, and so on. 3. The timing and magnitude of these effects determine the changes in the interest rate

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. H OW THE F ED A FFECTS THE I NTEREST R ATES Liquidity Effect Income Effect Price Level Effect Expectations Effect

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. M ONETARY P OLICY 1. The Federal Reserve-Institutional Details. 2. Money Supply Process – How the FED controls the money supply

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Fed Monetary Tools and Their Effects on the Money Supply

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Dollars Saved or Invested Interest Rate Investment Savings All Other Goods Real GDP Good X Price Level LRAS Natural GDP SRAS AD Institutional PPF Physical PPF Be able to show how a change in the money supply affects the price level (inflation), real GDP, unemployment, and interest rates in the short and long run.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. H OW THE F ED A FFECTS THE I NTEREST R ATES Liquidity Effect Income Effect Price Level Effect Expectations Effect