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1、Money and Inflation,4,In this chapter, you will learn,The classical theory of inflation causes effects social costs “Classical” assumes prices are flexible & markets clear Applies to the long run,CHAPTER 4 Money and Inflation,U.S. inflation and its trend, 1960-2006,slide 2,The connection between mon
2、ey and prices,Inflation rate = the percentage increase in the average level of prices. Price = amount of money required to buy a good. Because prices are defined in terms of money, we need to consider the nature of money, the supply of money, and how it is controlled.,CHAPTER 4 Money and Inflation,M
3、oney: Definition,Money is the stock of assets that can be readily used to make transactions.,CHAPTER 4 Money and Inflation,Money: Functions,medium of exchangewe use it to buy stuff store of valuetransfers purchasing power from the present to the future unit of accountthe common unit by which everyon
4、e measures prices and values,CHAPTER 4 Money and Inflation,Money: Types,1.fiat money has no intrinsic value example: the paper currency we use modity money has intrinsic value examples: gold coins, cigarettes in P.O.W. camps,CHAPTER 4 Money and Inflation,Discussion Question,Which of these are money?
5、 a.Currency b.Checks c.Deposits in checking accounts (“demand deposits”) d.Credit cards e.Certificates of deposit (“time deposits”),CHAPTER 4 Money and Inflation,The money supply and monetary policy definitions,The money supply is the quantity of money available in the economy. Monetary policy is th
6、e control over the money supply.,CHAPTER 4 Money and Inflation,The central bank,Monetary policy is conducted by a countrys central bank. In the U.S., the central bank is called the Federal Reserve (“the Fed”).,The Federal Reserve Building Washington, DC,CHAPTER 4 Money and Inflation,Money supply mea
7、sures, April 2006,amount ($ billions),assets included,symbol,CHAPTER 4 Money and Inflation,The Quantity Theory of Money,A simple theory linking the inflation rate to the growth rate of the money supply. Begins with the concept of velocity,CHAPTER 4 Money and Inflation,Velocity,basic concept: the rat
8、e at which money circulates definition: the number of times the average dollar bill changes hands in a given time period example: In 2007, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions in 2007 So, velocity = 5,CHAPTER 4 Money and Inflation,V
9、elocity, cont.,This suggests the following definition:,where V = velocity T = value of all transactions M = money supply,CHAPTER 4 Money and Inflation,Velocity, cont.,Use nominal GDP as a proxy for total transactions. Then,where P = price of output (GDP deflator) Y = quantity of output (real GDP) P
10、Y = value of output (nominal GDP),CHAPTER 4 Money and Inflation,The quantity equation,The quantity equationM V = P Yfollows from the preceding definition of velocity. It is an identity: it holds by definition of the variables.,CHAPTER 4 Money and Inflation,Money demand and the quantity equation,M/P
11、= real money balances, the purchasing power of the money supply. A simple money demand function: (M/P )d = k Ywherek = how much money people wish to hold for each dollar of income. (k is exogenous),CHAPTER 4 Money and Inflation,Money demand and the quantity equation,money demand: (M/P )d = k Y quant
12、ity equation: M V = P Y The connection between them: k = 1/V When people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low).,CHAPTER 4 Money and Inflation,Back to the quantity theory of money,starts with quantity equation assumes V is constant & exo
13、genous: With this assumption, the quantity equation can be written as,CHAPTER 4 Money and Inflation,The quantity theory of money, cont.,How the price level is determined: With V constant, the money supply determines nominal GDP (P Y ). Real GDP is determined by the economys supplies of K and L and t
14、he production function (Chap 3). The price level is P = (nominal GDP)/(real GDP).,CHAPTER 4 Money and Inflation,The quantity theory of money, cont.,Recall from Chapter 2: The growth rate of a product equals the sum of the growth rates. The quantity equation in growth rates:,CHAPTER 4 Money and Infla
15、tion,The quantity theory of money, cont., (Greek letter “pi”) denotes the inflation rate:,The result from the preceding slide was:,Solve this result for to get,CHAPTER 4 Money and Inflation,The quantity theory of money, cont.,Normal economic growth requires a certain amount of money supply growth to
16、 facilitate the growth in transactions. Money growth in excess of this amount leads to inflation.,CHAPTER 4 Money and Inflation,The quantity theory of money, cont.,Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now).,Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.,CHAPTER 4 Money and Inflation,Confronting the quantity theo
