Economics Chapter 14 ORU

if velocity and real gdp are not constant

If we drop the assumptions that velocity (BV) 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 2. Velocity 3. Real GDP Inflationary tendencies: M and V rise while Q falls Deflationary tendencies: M and V fall while Q rises

highlights of monetarism

(Continued) (c): An increase in velocity causes the AD curve to shift right from AD1 to AD2; Real GDP and price rise; unemployment falls (d): A decrease in velocity causes the AD curve to shift to the left from AD1 to AD2; Real GDP and price fall; unemployment rises

equation of exchange

An identity stating that the money supply (M) times velocity (V) must be equal to the price level (P) times Real GDP (Q): MV = PQ (PQ is nominal GDP)

what money supply changes effect

Changes in the money supply or changes in the rate of growth of the money supply can affect: 1. the supply of loans 2. real GDP 3. the price level 4. the expected inflation rate

money and the economy

Classical economists believed that changes in the money supply affect the price level in the economy; their position was based on the equation of exchange and on the simple quantity theory of money

from one shot inflation to continued inflation

Continued increase in aggregate demand can turn one-shot inflation into continued inflation (Ex 6) The Effect of Continued Declines in SRAS: This could happen, but isn't likely Today, both the CPI and Real GDP are higher than in 1960, which means that we have experienced continued inflation, but that this has been accompanied by a generally rising Real GDP

causes of continued inflation

If continued increases in aggregate demand cause continued inflation, what causes continued increases in aggregate demand? Economists widely agree that the only factor that can change continually in such a way as to bring about continued increases in aggregate demand is the money supply

demand side induced one shot inflation

In Ex 4(a), the AD curve shifts rightward because the money supply increase Employers, however, are unaware of that; what they see is part (b) in which they end up paying higher wages to their employees and the SRAS curve shifts leftward; they mistakenly conclude that the rise in the price level originated with a supply-side factory (higher wage rates), not with a demand-side factor (an increase in the money supply)

inflation

In everyday usage, "inflation" refers to any increase in the price level; economists, though, like to differentiate between two types of increases in the price level: a one-shot increase and a continued increase

velocity

The average number of times a dollar is spent to buy final goods and services in a year

income effect

The change in the interest rate due to a change in Real GDP

expectations effect

The change in the interest rate due to a change in the expected inflation rate

price level effect

The change in the interest rate due to a change in the price level

liquidity effect

The change in the interest rate due to a change in the supply of loanable funds

nominal interest rate

The interest rate actually charged (or paid) in the market; the market interest rate; Nominal interest rate = Real interest rate + Expected inflation rate

real interest rate

The nominal interest rate minus the expected inflation rate. When the expected inflation rate is zero, the real interest rate equals the nominal interest rate

simple quantity theory of money

The theory which assumes that velocity (V) and Real GDP (Q) are constant and predicts that changes in the money supply (M) lead to strictly proportional changes in the price level (P) Classical economists made the following assumptions: 1. Changes in velocity are so small that, for all practical purposes, velocity can be assumed to be constant (especially over short periods) 2. Real GDP, or Q, is fixed in the short run

four monetarist positions

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)

AD and AS in the simple quantity theory of money

(Exhibit 2(a)): An increase in the money supply will increase aggregate demand and shift the AD curve to the right A decrease in the money supply will decrease aggregate demand and shift the AD curve to the left An increase in velocity will increase aggregate demand and shift the AD curve to the right A decrease in velocity will decrease aggregate demand and shift the AD curve to the left (Exhibit 2(b)): The AS curve is vertical at this level of Real GDP (Exhibit 2(c): The increase in the money supply shifts the AD curve from AD1 to AD2 and pushes up the price level from P1 to P2 A decrease in the money supply shifts the AD curve from AD1 to AD3 and pushes the price level down from P1 to P3

interest rate and loanable funds market

(Part 1 of 3)

interest rate and loanable funds market

(Part 2 of 3)

interest rate and loanable funds market

(Part 3 of 3)

highlights of monetarism

(a): Monetarists believe that changes in the money supply will change aggregate demand (b): A decrease in the money supply with velocity held constant, will shift the AD curve to the left from AD1 to AD2; Real GDP will be reduced to Q1 and price reduced to P2; unemployment will rise

effect of money supply on interest rate

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 The timing and magnitude of these effects determine the changes in the interest rate

continued inflation

A continued increase in the price level Suppose the CPI for years 1 to 5 is as follows: (see picture) Each year, the CPI is higher than the year before

one shot inflation

A one-time increase in the price level; an increase in the price level that does not continue

monetarists

Economists who call themselves monetarists have not been content to rely on the simple quantity theory of money; they do not hold that velocity is constant, nor do they hold that output is constant

monetarism and AD-AS

Monetarists believe: 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 Can a change in velocity offset a change in the money supply? The monetarist view is that: 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 thus change sin Real GDP and the price level

can you get rid of inflation with price controls

Not really; there are consequences of price ceilings below the equilibrium price; one is that nonmoney rationing devices will be used, which results in long lines