Chapter 14 Money and The Economy: Pre-Class & In-Class Activities Packet Name/I.D. Number :_________________________________________ Section: ______________ Date: __________________ Part 3. Discussion Questions and Problems 2. What is the Equation of Exchange presented in the form of an Identity? ___________________________________________________ _____________ where: M represents Money Supply; V represents Velocity; ? means must be equivalent to; P represents Price; and Q represents Real GDP. 4.Can the money supply support a GDP level greater than itself? Explain your answer. ___________________________________________________________________________________________________________________________ 6. In monetarism, how will each of the following affect the price level in the short run? A. An increase in velocity__________________________________________________________________________________________ B. A decrease in velocity___________________________________________________________________________________________ C. An increase in the money supply__________________________________________________________________________________ D. A decrease in the money supply___________________________________________________________________________________ 8.To a potential borrower, which would be more important: the nominal interest rate or the real interest rate? Explain. ___________________________________________________________________________________________________________________________ 10. According to monetarism, an increase in the money supply will lead to a rise in Real GDP in the long run. Do you agree or disagree ? Why? _____________________________________________________________________________________________________________________

economics

by: Roger A. Arnold

Thirteenth Edition

mrsor/Downloads/Arnold%20%20Ch14.pdf 1 19 100% + H O 5/4/2015 CHAPTER 14 The Equation of Exchange Monetarism Money and The One-Shot Inflation and Continued Economy Inflation ECONOMICS INTHISLECTURE The Money Supply and Interest Rates Nominal and Real Interest Rates MONEY AND THE PRICE LEVEL THE CLASSICAL VIEW EQUATION OF EXCHANGE Classical economists believed that changes in the money supply affect the price level in the M XV= PxQ economy, but not the level of output; Based upon the Equation of Exchange which where: is an identity stating that the money supply times velocity* must be equal to the price level M represents Money Supply times Real GDP. V represents Velocity* = means must be equal to M x V = P xQ P represents Price The average number of times a dollar is spent to buy final Q represents Real GDP goods and so CALCULATING VELOCITY EQUATION OF EXCHANGE - REVISITED In a large economy such as ours, it is MX V = Total Spending impossible to simply count how many P x Q . Total Sales Revenue of Business Firms (GDP) times each dollar changes hands 50: Total Spending (velocity). As an alternative: Total Sales Revenue of Business Firms M x V=Px Q GDP is equal to P x Q M x V = GDP V =GDP*/M* 1 5/4/2015 ASSUMPTIONS AND PREDICTIONS OF JUHL SIMPLE QUANTITY THEORY OF MONEY THE SIMPLE QUANTITY THEORY OF MONEYCHAPTER 14 The Equation of Exchange > Monetarism Money and The > One-Shot Inflation and Continued Economy Inflation ECONOMICS INTHISLECTURE The Money Supply and Interest Rates - Nominal and Real Interest Rates 04 14 . 2 MONEY AND THE PRICE LEVEL THE CLASSICAL VIEW EQUATION OF EXCHANGE - Classical economists believed that changes in the money supply affect the price level in the M XV= P x Q economy, but not the level of output; Based upon the Equation of Exchange which where: is an identity stating that the money supply times velocity* must be equal to the price level M represents Money Supply times Real GDP. V represents Velocity* = means must be equal to M x V = P x Q P represents Price *The average number of times a dollar is spent to buy final Q represents Real GDP goods and services in a year. CALCULATING VELOCITY EQUATION OF EXCHANGE - REVISITED In a large economy such as ours, it is MX V - Total Spending impossible to simply count how many P x Q = Total Sales Revenue of Business Firms (GDP) times each dollar changes hands (velocity). so: Total Spending As an alternative: Total Sales Revenue of Business Firms M x V =P x Q GDP is equal to P x Q M x V = GDP V = GDP*/ M*4 /9 150% + MONETARISM IN A AD-AS MONETARISM IN A AD-AS FRAMEWORK IF: VELOCITY INCREASES FRAMEWORK IF: VELOCITY DECREASES LRAS SRAST SRAS? MVL Price Level \\AD, ( = $8CO billion: V = 3) Real GDP C49 - 20 MONETARIST VIEW OF THE ECONOMY 1.What do monetarists predict will happen in the short run and in the long run as a result of each of the following (in each case, assume the economy is currently in long-run equilibrium)? Monetarists believe: a. Velocity rises. . the economy is self-regulating. As velocity rises. the AD curve shifts to the right. In the short run. P and @ rise. In the long run, Q will return to its original changes in velocity and the money SELFTEST level, and P will be higher than it was in the short run. supply can change aggregate demand. b. Velocity falls. As velocity falls, the AD curve shifts to the left. In the short changes in velocity and the money run. P and @ fall. In the long run, @ will return to its original supply will change the price level and evel, and P will be lower than it was in the short run. (continued) Real GDP in the short run but only the price level in the long run. c. The money supply rises. 310 INFLATION As the money supply rises, the AD curve INCREASE IN THE PRICE LEVEL I shifts to the right. In the short run, P and Q rise. In the long run, Q will return to its One-Shot Inflation - A one-time original level, and P will be higher than it increase in the price level. An increase was in the short run. in the price level that does not SELFTEST d. The money supply falls. continue. As the money supply falls, the AD curve shifts to the left. In the short run, P and Q fall. Year CPI In the long run, Q will return to its original level, and P will be lower than it was in the 1 100 short run 110 110 UIAWN 110 110 CH 14 . 23 CH H .5 /9 150% + ONE-SHOT INFLATION: DEMAND-SIDE INDUCED I ONE-SHOT INFLATION: DEMAND-SIDE INDUCED II The aggregate Because the Real GDP the SRAS, 10 SRAS demand curve shifts point : 10 2 economy produces (@2) is point 2 10 3 rightward from AD1 to greater than Natural Real GDP, LRAS the unemployment rate that AD2. exists is less than the natural LRAS SPAS, unemployment rate. >As a result, the price Wage rates rise, and the short- level increases from run aggregate supply curve Price Level P1 to P2. shifts leftward from SRAS1 to SRAS2. The economy moves Long-run equilibrium is at point from point ] to point Real GDP 3. AD. 2. Real GOF ONE-SHOT INFLATION: SUPPLY-SIDE ONE-SHOT INFLATION: SUPPLY-SIDE INDUCED I INDUCED II SPAS, TO SPAS The short-run point : to 2. Because the Real GDP the SHAS TO SRAS economy produces (@2) is less aggregate supply LRAS than Natural Real GDP, the point 2 back161 curve shifts leftward SRASZ unemployment rate that exists SPAS , is greater than the natural SPAS from SRAS1 to SRAS2. unemployment rate. Some economists argue that As a result, the price when this happens, wage rates Price Level will fall and the short-run level increases from egate supply curve wil price Level shift rightward from SRA$2 P1 to P2; the (back to SRAST). economy moves from AD, Long-run equilibrium is at point point 1 to point 2. Real GOP Real GDF CONTINUOUS INFLATION ! BEGINS WITH SHIFT IN AD . Inflation The aggregate demand curve shifts rightward from AD, to Increase in the Price Level II AD.. LRAS The economy initially moves from point ] to point 2 and finally to point 3. Year CPI Continued increases in the 100 price level are brought about through continued increases in ice Level 110 aggregate demand. 120 UIAWN 130 140 1 9 Real GOP CH - 307/9 - 150% + THE INTEREST RATE AND THE LOANABLE THE INTEREST RATE AND THE LOANABLE FUNDS MARKET FUNDS MARKET . A Fed open market purchase increases Rate in reserves in the banking system and therefore increases the supply of loanable funds. As a result, the interest rate declines. Loarable Funds (Que) To supply bands is to demand loanable funds. To demand bands is to supply loonoble funds ON 14 - 38 LIQUIDITY EFFECT INCOME EFFECT I - The change in the interest When real GDP rate due to a change in the supply of loanable increases, both the funds. A Fed open market supply of and the purchase increases demand for reserves in the banking system and therefore loanable funds increases the supply of increase. loanable funds. As a result, the interest rate declines. INCOME EFFECT II PRICE LEVEL EFFECT - The overall effect on the - When the price level rises, interest rate is that, the purchasing power of usually, the demand for money falls. People may loanable funds increases therefore increase their by more than the supply demand for credit or so that the interest rate loanable funds to borrow the funds necessary to buy rises. X-X a fixed bundle of goods. - The change in the interest - This change in the interest rate due to a change in rate due to a change in the real GDP is called the X- price level is called the income effect. price-level effect.8 /9 150% EXPECTATIONS EFFECT I EXPECTATIONS EFFECT II - Borrowers (demanders of - Lenders (the suppliers of loanable funds) will be loanable funds) require a willing to pay more higher interest rate to interest for their loans compensate them for the less valuable dollars with which the because they expect to loan will be repaid be paying back the loans with dollars that have less - In effect, the supply of loanable funds curve shifts buying power than the leftward. dollars they are The change in the interest rate borrowing. due to a change in the expected inflation rate. WHAT HAPPENS TO THE INTEREST RATE AS THE WHAT HAPPENS TO THE INTEREST RATE MONEY SUPPLY CHANGES? AS THE MONEY SUPPLY CHANGES? Point 1 in time: Fed says it will increase the A change in the money supply affects growth rate of the money supply. the economy in many ways. -Point 2 in time: If the expectations effect kicks in immediately, then . .. Changing the supply of loanable funds Point 3 in time: Interest rates rise. directly, changing Real GDP and Point 4 in time: Liquidity effect kicks in. therefore changing the demand for and Point 5 in time: As a result of what happened supply of loanable funds, changing the at point 4, the interest rate drops. expected inflation rate, and so on. The The interest rate is now lower than it was at timing and magnitude of these effects point 3. determine the changes in the interest rate. HOW THE FED AFFECTS THE INTEREST RATES NOMINAL INTEREST RATE Liquidity Effect - The interest rate actually charged (or paid) in the market; the market A Real GDP interest rate. Income Effect -Nominal interest rate - Real interest A Price Level rate + Expected inflation rate. Price Level Effect - ization Rate 1% Expectations Effect - Loanable FundsREAL INTEREST RATE 1. If the expected inflation rate is 4 percent and the nominal interest rate is 7 percent, what is the real interest rate? The nominal interest rate minus the expected inflation rate. When the expected inflation rate is zero, the real SELFTEST interest rate equals the nominal Three percent. interest rate. Real interest rate = Nominal interest rate - Expected inflation rate 1% CH 34 - 50 2. Is it possible for the nominal interest rate to 3. The Fed only affects the interest rate via the immediately rise following an increase in liquidity effect. Do you agree or disagree? the money supply? Explain your answer. Explain your answer. Certainly, the Fed directly affects the supply of loanable funds and the interest rate through an open market SELFTEST Yes, it is possible if the expectations effect operation. But it works as a catalyst to indirectly affect the SELFTEST immediately sets in and outweighs the loanable funds market and the interest rate via the changes in Real GDP, the price level, and the expected liquidity effect. inflation rate. We can say this: The Fed directly affects the interest rate by means of the liquidity effect, and it indirectly affects the interest rate by means of the income, price-level, and expectations effects. CH 14 . 32 WALL STREET JOURNAL The Wall Street Journal is a is a rich source of information which provides real life examples of micro- and macro economic activities. Check today's issue to see the most current news. http://www.wsj.com2 /9 150% + ASSUMPTIONS AND PREDICTIONS OF SIMPLE QUANTITY THEORY OF MONEY THE SIMPLE QUANTITY THEORY OF MONEY The theory that assumes* that velocity () and Real GDP (Q) are constant and Assumptions of Simple Predictions of Simple predicts that changes in the money Quantity Theory Quantity Theory supply (M) lead to strictly proportional Change Change M in P changes in the price level (P). in M 3 500 1.000 1,000 1,000 + 100% + 100% 1,500 1.000 + 50 4 50 M x VEP x Q 1,200 1,000 - 20 - 20 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 *Note: "M x V = P x Q" is an identity, that changes in M lead to strictly proportional changes in P. Think of Q as not a theory. "so many units of goods" and of P as the "average price paid per unit of these goods.") THE AD CURVE IN THE SIMPLE AGGREGATE DEMAND IN THE SIMPLE QUANTITY THEORY OF MONEY 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) Price Level Change in M and/or V will cause a change in AD AD with V constant (a) RGDP fixed in short run (b) -the level of Real GDP is assumed to be constant in the short run M increases/decreases (c) causing AD to shift VELOCITY AND REAL GDP VARIABLE VELOCITY AND REAL GDP VARIABLE If we drop the assumptions that velocity M x VEP xQ (V) and Real GDP (Q) are constant, we If the equation of exchange holds, then have a more general theory of the P =M x V factors that cause changes in the price Q level. In this theory, changes in the price level depend on three variables: An increase in M and/or V and/or a decrease in Q will cause prices to rise. 1. Money supply (M) 2. Velocity (V) 3. Real GDP (Q) CH 14 - 12 CH 14 - 113 /9 150% + 1. If M times V increases, why does What is the difference between the P times Q have to rise? equation of exchange and the simple If M times V increases, total expenditures quantity theory of money? increase. In other words, people spend The equation of exchange is a truism: MV necessarily more. For example, instead of spending $3 equals PQ. This is similar to saying that 2 + 2 billion on goods and services, they spend $4 necessarily equals 4. It cannot be otherwise. The SELFTEST SELFTEST billion. But if there is more spending (greater simple quantity theory of money, which is built on the equation of exchange, can be tested against total expenditures), there must be greater real-world events. total sales. P times Q represents this total (continued) dollar value of sales. CH 14 - 14 That is, the simple quantity theory of money . Predict what will happen to the AD curve as a result assumes that both velocity and Real GDP are of each of the following: constant and then, based on these a. The money supply rises assumptions, predicts that changes in the b. Velocity falls. money supply will be strictly proportional to c. The money supply rises by a greater percentage than velocity falls. changes in the price level. Because this d. The money supply falls. SELFTEST prediction can be measured against real- SELFTEST a. AD curve shifts rightward. world data, the simple quantity theory of b. AD curve shifts leftward. money may offer insights into the way the C. AD curve shifts rightward economy works. The equation of exchange d. AD curve shifts leftward. does not do this. 01 14 - 15 CH 34 - 16 MONETARISM IN A AD-AS MONETARISM IN A AD-AS FRAMEWORK IF: FRAMEWORK IF: MONEY SUPPLY INCREASES MONEY SUPPLY DECREASES CH 14 . 116 /9 150% CONTINUOUS INFLATION II 2 INFLATION QUESTIONS The short-run aggregate supply Start SRAS. 10 5HAS, 1. Can continued declines in SRAS curve shifts leftward from SRAST then folicin the artown to SRAS2. cause continued inflation? LRAS The economy initially moves Not likely as it is not supported by from point ] to point 2. recent history, and, wages are not The economy will return to point 1 unless there is an likely to increase as demand for labor increase in aggregate decreases. demand. We see here that continued Price Le increases in the price level are brought about through 2. What causes continued increases continued increases in in aggregate demand? aggregate demand Continued | in M - Continued | in AD - Continued inflation CHS - 31 1. The prices of houses, cars, and 2. Is continued inflation likely to be television sets have increased. Has there been inflation? supply-side induced? Explain We cannot answer this question based on the your answer. information given. We know only that three prices No. For continued inflation (continued have gone up; we don't know if other prices (in the ncreases in the price level) to be the result SELFTEST SELFTEST economy) have gone up, if other prices have gone of continued decreases in SRAS, workers down, or if some have gone up and others have gone down. To determine whether inflation has would have to continually ask for and occurred, we have to know what has happened to eceive higher wages while output was the price level, not simply to three prices. dropping and the unemployment rate ising. This set of conditions is not likely. 3. What type of inflation is Milton Friedman ECONOMIC VARIABLES AFFECTED BY referring to when he says that "inflation is A CHANGE IN THE MONEY SUPPLY always and everywhere a monetary phenomenon"? The supply of loans Real GDP SELFTEST The price level, and Continued inflation. The expected inflation rate