1. Ch. 14: Money and the Economy Del Mar College John Daly ©2003 South-Western Publishing, A Division of Thomson Learning

2. Money and the Price Level The Equation of Exchange is MV = PQ The money supply (M) multiplied by the Velocity (V) must be equal to the price level (P) times Real GDP (Q). Velocity is the average number of times a dollar is spent to buy final goods and services in a year.

3. The Equation of Exchange In a large economy such as ours, it is impossible to figure out how many times each dollar has changed hands. Velocity must be equal to GDP divided by the average money supply.

4. Interpreting the Equation of Exchange The money supply multiplied by velocity must equal the price level times Real GDP M x V  P x Q The money supply multiplied by velocity must equal GDP: M x V  GDP Total spending or expenditures (measured by MV) must equal the total sales revenues of business firms (measured by PQ): MV  PQ

5. From the Equation of Exchange to the Simple Quantity Theory of Money Fisher and Marshall assumed changes in velocity are so small that for all practical purposes velocity can be assumed to be constant. Fisher and Marshall assumed Real GDP is fixed in the short run. From these assumptions, we have the simple quantity theory of money: changes in M will bring about proportional changes in P.

6. The Simple Quantity Theory in an AD-AS Framework MV is equal to total expenditures. Total expenditures is equal to C+I+G+(EX-IM) Since MV=TE, MV=C+I+G+(EX-IM) A change in the money supply or a change in velocity will change aggregate demand and therefore lead to a shift in the AD curve. But, in the simple quantity theory of money, velocity is assumed to be constant.

7. The Simple Quantity Theory in an AD-AS Framework

8. Dropping the Assumptions that V and Q are Constant Remember: M x V  P x Q, then P = M x V Q Money supply, velocity, and Real GDP determine the Price Level. An increase in M or V or a decrease in Q will cause prices to rise. This is inflation. A decrease in M or V or an increase in Q will cause prices to fall. This is deflation.

9. Q & A If M times V increases, why does P times Q have to rise? What is the difference between the equation of exchange and the simple quantity theory of money? Predict what will happen to the AD curve as a result of each of the following: The money supply rises; Velocity falls; The money supply rises by a greater percentage than velocity falls; The money supply falls.

10. Monetarism: Key Views Velocity changes in a predictable way. Aggregate Demand depends on the money supply and on Velocity. The SRAS curve is upward sloping. The Economy is Self- Regulating (Prices and Wages are flexible)

11. Monetarism in an AD-AS Framework

12. The Monetarist View of the Economy The economy is self-regulating Changes in velocity and the money supply can change aggregate demand. 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.

13. The Monetarist View of the Economy Changes in velocity are not likely to offset changes in the money supply. Changes in the money supply will largely determine changes in aggregate demand, and therefore changes in Real GDP and the price level. An increase in the money supply will raise aggregate demand and increase both Real GDP and the price level in the short run and increase the price level in the long run. A decrease in the money supply will lower aggregate demand and decrease both Real GDP and price level in the short run and decrease price level in the long run.

14. Q & A What do monetarists predict will happen in the short run and in the long run as a result of each of the following: Velocity rises; Velocity falls; The money supply rises; The money supply falls. Can a change in velocity offset a change in the money supply (on aggregate demand)? Explain your answer.

15. Inflation Inflation refers to any increase in the price level One shot inflation is a one time increase in price level. There are several theories on one-shot inflation:

16. One-Shot Inflation: Demand Side Induced

17. One-Shot Inflation: Supply-Side Induced

18. Continued Inflation From One- Shot Inflation Continued increases in aggregate demand cause continued increases in inflation, or continued inflation.

19. Changing One Shot Inflation Into Continued Inflation

20. What Causes Continued Increases In Aggregate Demand? The only factor that can change continually in such a way as to bring about continued increases in aggregate demand is the money supply. Money Supply is the only factor that can continually increase without causing a reduction in one of the four components of total expenditures: consumption, investment, government purchases, or net exports.

21. Q & A The prices of houses, cars, and television sets have increased. Has there been inflation? Is continued inflation likely to be supply- sided? Explain your answer. What type of inflation is Milton Friedman referring to when he says, “Inflation is always and everywhere a monetary phenomenon”?

22. Money and Interest Rates What economic variables are affected by a change in the money supply: 1.Money & the supply of loans 2.Money & the Real GDP 3.Money & the Price Level 4.They can also affect the expected inflation rate.

23. Money and Interest Rates Anything that affects either the supply of loanable funds or the demand for loanable funds will obviously affect the interest rate. A change in the interest rate due to a change in the supply of loanable funds is called the liquidity effect. When Real GDP increases, both the supply of and demand for loanable funds increase. The demand for loanable funds increases more than the supply of loanable funds, so that the interest rate rises. This change in interest rate is called the Income effect.

24. Money and Interest Rates, cont. When the price level rises, the purchasing power of money falls, and people may increase their demand for credit or loanable funds in order 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. An expected inflation rate increases the demand for loanable funds and decreases the supply of loanable funds, so that the interest rate is higher. This change in the interest rate is called the expectations effect.

25. The Interest Rate and the Loanable Funds Market

26. What Happens to the Interest Rate as the Money Supply Changes? A change in the money supply affects the economy in many ways: 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.

27. The Nominal and Real Interest Rates Nominal interest rate is the interest rate that comes about through the interaction of the demand for and supply of loanable funds. The nominal interest rate may not be the true cost of borrowing because part of the nominal interest rate is a reflection of the expected inflation rate. The Real Interest Rate is equal to the Nominal Interest Rate minus the Expected Inflation Rate.

28. Q & A If the expected inflation rate is 4% and the nominal interest rate is 7%, what is the real interest rate? Is it possible for the nominal interest rate to immediately rise following and increase in the money supply? Explain your answer. “The Fed only affects the interest rate via the liquidity effect.” Do you agree or disagree? Explain your answer.