Chapter 14

Money and the Economy
14
CHAPTER
Money and the Price Level
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.
The Equation of Exchange
The equation of exchange is an identity stating that the money supply
(𝑀) multiplied by velocity (𝑉) must be equal to the price level (𝑃) times
Real GDP (𝑄).
𝑀𝑉 ≑ 𝑃𝑄
where ≑ means β€œmust be equal to.” This is an identity, and an identity is
valid for all values of the variables.
Money and the Price Level
The Equation of Exchange
 As we learned in an earlier chapter, velocity is the average number
of times a dollar is spent to buy final goods and services in a year.
 For example, assume an economy has only five $1 bills. Suppose
that over the course of the year, the first dollar bill changes hands 3
times; the second, 5 times; the third, 6 times; the fourth, 2 times; and
the fifth, 7 times.
 Given this information, we can calculate the average number of
times a dollar changes hands in purchases. In this case, the number
is 4.6, which is velocity.
Money and the Price Level
The Equation of Exchange
In reality, counting how many times each dollar changes hands
is impossible; so calculating velocity as we did in our example is
impossible. In reality, we use a different method.
We compute velocity using the equation of exchange:
𝑃𝑄 𝐺𝐷𝑃
𝑉≑
≑
𝑀
𝑀
Money and the Price Level
The Equation of Exchange
The equation of exchange can be interpreted in different ways:
1. The money supply multiplied by velocity must equal the price level
times Real GDP: 𝑀 × π‘‰ ≑ 𝑃 × π‘„
2. The money supply multiplied by velocity must equal GDP: 𝑀 × π‘‰ ≑
𝐺𝐷𝑃 (because 𝑃 × π‘„ ≑ 𝐺𝐷𝑃).
3. Total spending or expenditures of buyers (measured by 𝑀𝑉) must
equal the total sales revenues of business firms (measured by 𝑃𝑄):
𝑀𝑉 ≑ 𝑃𝑄
Money and the Price Level
From the Equation of Exchange to the Simple Quantity
Theory of Money
The equation of exchange is an identity, not an economic theory. To turn it
into a theory, we make some assumptions about the variables in the
equation. Many eighteenth-century classical economists, as well as
American economist Irving Fisher (1867–1947) and English economist
Alfred Marshall (1842–1924), 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 of time).
2.
Real GDP, or 𝑄, is fixed in the short run.
Money and the Price Level
From the Equation of Exchange to the Simple Quantity
Theory of Money
 With these two assumptions, we have the simple
quantity theory of money: If 𝑉 and 𝑄 are constant, then
changes in 𝑀 will bring about strictly proportional
changes in 𝑃.
 In other words, the simple quantity theory of money
predicts that changes in the money supply will bring
about strictly proportional changes in the price level.
Money and the Price Level
Money and the Price Level
From the Equation of Exchange to the Simple Quantity
Theory of Money
 How well does the simple quantity theory of money predict?
The answer is that the strict proportionality between changes
in the money supply and changes in the price level does not
show up in the data (at least not very often).
 Generally, though, the evidence supports the spirit (or
essence) of the simple quantity theory of money: the higher
the growth rate in the money supply, the greater the growth
rate in the price level.
Money and the Price Level
From the Equation of Exchange to the Simple Quantity
Theory of Money
 To illustrate, we would expect that a growth rate in the money
supply of, say, 40 percent would generate a greater increase
in the price level than, say, a growth rate in the money supply
of 4 percent.
 Generally, this effect is what we see. For example, countries
with more rapid increases in their money supplies often
witness more rapid increases in their price levels than do
countries that witness less rapid increases in their money
supplies.
Money and the Price Level
The Simple Quantity Theory of Money in an AD–AS
Framework
AD curve in the Simple Quantity Theory of Money
Recall that one way of interpreting the equation of exchange is that the
total expenditures of buyers (MV) must equal the total sales of sellers
(𝑃𝑄). So,
𝑀𝑉 = π΄π‘”π‘”π‘Ÿπ‘’π‘”π‘Žπ‘‘π‘’ 𝐸π‘₯π‘π‘’π‘›π‘‘π‘–π‘‘π‘’π‘Ÿπ‘’π‘  (𝐴𝐸).
However,
𝐴𝐸 = 𝐢 + 𝐼 + 𝐺 + 𝑋 βˆ’ 𝑀
β†’ 𝑀𝑉 = 𝐢 + 𝐼 + 𝐺 + 𝑋 βˆ’ 𝑀
Money and the Price Level
The Simple Quantity Theory of Money in an AD–AS
Framework
AD curve in the Simple Quantity Theory of Money
At a given price level, anything that changes 𝐢, 𝐼, 𝐺, 𝑋 or 𝑀 changes
aggregate demand and thus shifts the aggregate demand (𝐴𝐷) curve. If
𝑀𝑉 equals 𝐢 + 𝐼 + 𝐺 + 𝑋 βˆ’ 𝑀, then a change in the money supply (𝑀)
or a change in velocity (𝑉) will change aggregate demand and therefore
lead to a shift in the 𝐴𝐷 curve.
In other words, aggregate demand depends on both the money supply
and velocity. But in the simple quantity theory of money, velocity is
assumed to be constant. Thus, only changes in the money supply can
shift the 𝐴𝐷 curve.
Money and the Price Level
The Simple Quantity Theory of Money in an AD–AS
Framework
The AS curve in the simple quantity theory of money
In the simple quantity theory of money, the level of Real
GDP is assumed to be constant in the short run. The AS
curve is vertical at that constant level of Real GDP.
Money and the Price Level
The Simple Quantity Theory of Money in an AD–AS
Framework
AD and AS in the simple quantity theory of money
Money and the Price Level
Dropping the Assumptions that 𝑽 and 𝑸 Are Constant
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
2. Velocity
3. Real GDP
Let’s again start with the equation of exchange: 𝑀 × π‘‰ ≑ 𝑃 × π‘„
If the equation of exchange holds, then:
𝑃≑
𝑀×𝑉
𝑄
Money and the Price Level
Dropping the Assumptions that 𝑽 and 𝑸 Are Constant
 This last equation shows that the price level depends on the money
supply, velocity, and Real GDP.
 What kinds of changes in 𝑀, 𝑉, and 𝑄 will bring about inflation (an
increase in the price level), ceteris paribus?
Inflationary tendencies: 𝑀 ↑, 𝑉 ↑, 𝑄 ↓
 What will bring about deflation (a decrease in the price level), ceteris
paribus?
Deflationary tendencies: 𝑀 ↓, 𝑉 ↓, 𝑄 ↑
Monetarism
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.
The Four Monetarist Positions
1.
2.
3.
4.
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)
Monetarism
The Four Monetarist Positions
1. Velocity changes in a predictable way
 Monetarists do not assume that velocity is constant, but rather that it
can and does change. However, they believe that velocity changes
in a predictable way, that is, not randomly, but in a way that can be
understood and predicted.
 Monetarists hold that velocity is a function of certain variablesβ€”the
interest rate, the expected inflation rate, the frequency with which
employees receive paychecks, and moreβ€”and that changes in it
can be predicted.
Monetarism
The Four Monetarist Positions
2. Aggregate demand depends on the money supply and on velocity
Just like the Keynesians focus on components of 𝐴𝐸, the Monetarists
focus on the money supply (𝑀) and velocity (𝑉). For example,
Keynesians argue that changes in 𝐢, 𝐼, 𝐺, 𝑋, or 𝑀 can change aggregate
demand, whereas monetarists argue that 𝑀 and 𝑉 can change aggregate
demand.
3. The 𝑺𝑹𝑨𝑺 curve is upward sloping
In the simple quantity theory of money, the level of Real GDP (𝑄) is
assumed to be constant in the short run. So the aggregate supply curve is
vertical. According to monetarists, Real GDP may change in the short run,
and therefore the 𝑆𝑅𝐴𝑆 curve is upward sloping.
Monetarism
The Four Monetarist Positions
4. The economy is self-regulating (prices and wages are
flexible)
Similar to Classical economists, Monetarists believe that prices and
wages are flexible. Monetarists therefore believe that the economy
is self-regulating; it can move itself out of a recessionary or
inflationary gap and into long-run equilibrium, producing Natural
Real GDP.
Monetarism
Monetarism and AD–AS
Monetarism
Monetarism and AD–AS
Monetarism
The Monetarist View of the Economy
According to the diagrams, the monetarists believe that:
 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.
Monetarism
The Monetarist View of the Economy
 We need to make one other important point with respect to
monetarists. Consider this question: Suppose velocity falls and
the money supply rises. Can a change in velocity offset a
change in the money supply?
 Monetarists think that this conditionβ€”a change in velocity
completely offsetting a change in the money supplyβ€”does not
occur often. They believe (1) that velocity does not change very
much from one period to the next (i.e., it is relatively stable) and
(2) that changes in velocity are predictable.
Monetarism
The Monetarist View of the Economy
 So in the monetarist view of the economy, changes in velocity
are not likely to offset changes in the money supply.
Therefore, changes in the money supply will largely determine
changes in aggregate demand and thus changes in Real GDP
and the price level.
 According to monetarists, for all practical purposes, an
increase in the money supply will raise aggregate demand,
increase both Real GDP and the price level in the short run,
and increase only the price level in the long run. A decrease in
the money supply will lower aggregate demand, decrease
both Real GDP and the price level in the short run, and
decrease only the price level in the long run.
Inflation
In everyday usage, the word 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.
One-Shot Inflation
One-shot inflation can be thought of as a one-shot, or one-time,
increase in the price level. More precisely, if price level increases but
not on a continued basis, we call the price increase β€˜one-shot inflation’.
Suppose the CPI for years 1 to 5 is as follows:
Inflation
One-shot inflation: demand-side induced
Price levels that go from 𝑃1 to 𝑃2 to 𝑃3 may seem like more than a oneshot increase. But because the price level stabilizes (at 𝑃3 ), we cannot
characterize it as continually rising. So the change in the price level is
representative of one-shot inflation.
Inflation
One-shot inflation: supply-side induced
Inflation
Continued Inflation
Continued inflation can be demand-side induced (Demand-pull
inflation) or supply-side induced (Cost-push inflation)
Demand-pull inflation is an inflation that results from an initial
increase in aggregate demand.
Demand-pull inflation may begin with any factor that increases
aggregate demand, e.g., increases in the quantity of money,
increases in government purchases, or cuts in net taxes, an
increase in exports etc.
29
Inflation
Demand-pull inflation
This Figure illustrates
the start of a demandpull inflation.
Starting from full
employment, an
increase in aggregate
demand shifts the AD
curve rightward.
30
Inflation
Demand-pull inflation
Real GDP
increases, the
price level rises,
and an
inflationary gap
arises.
The rising
price level is
the first step
in the
demand-pull
inflation.
31
Inflation
Demand-pull
inflation
This Figure
illustrates the
money wage
response.
The higher level
of output means
that real GDP
exceeds potential
GDPβ€”an
inflationary gap.
32
Inflation
Demand-pull
inflation
The money
wage rises and
the SRAS curve
shifts leftward.
Real GDP
decreases back
to potential
GDP but the
price level rises
further.
33
Inflation
Demand-pull
inflation
This Figure
illustrates a
demand-pull
inflation spiral.
Aggregate
demand keeps
increasing and the
process just
described repeats
indefinitely.
34
Inflation
Demand-pull inflation
Although any of several
factors can increase
aggregate demand to start a
demand-pull inflation, only
an ongoing increase in the
quantity of money can allow
it to continue.
Demand-pull inflation
occurred in the United States
during the late 1960s and
early 1970s.
35
Inflation
Cost-push inflation is an inflation that results from an
initial increase in costs.
There are two main sources of increased costs:
 An increase in the money wage rate
 An increase in the money price of raw materials, such as
oil.
36
Inflation
Cost-push inflation
This Figure
illustrates the start
of cost-push
inflation.
A rise in the price
of oil decreases
short-run
aggregate supply
and shifts the
SRAS curve
leftward.
37
Inflation
Cost-push
inflation
Real GDP
decreases and
the price level
risesβ€”a
combination
called stagflation.
The rising price
level is the start
of the cost-push
inflation.
38
Inflation
Cost-push inflation
The initial increase in costs creates a one-shot rise in the
price level, not a continued inflation.
To create continued inflation, aggregate demand must
increase; which can happen because the Government or
the central bank may react to the rise in unemployment by
increasing aggregate demand.
39
Inflation
Cost-push
inflation
This Figure
illustrates an
aggregate demand
response to
stagflation, which
might arise because
the CB stimulates
demand to counter
the higher
unemployment rate
and lower level of
real GDP.
40
Inflation
Cost-push
inflation
The increase in
aggregate
demand shifts
the AD curve
rightward.
Real GDP
increases and
the price level
rises again.
41
Inflation
Cost-push
inflation
This Figure
illustrates a
cost-push
inflation spiral.
42
Inflation
Cost-push
inflation
If the oil producers raise
the price of oil to try to
keep its relative price
higher, and the Govt. or
the central bank responds
with an increase in
aggregate demand, a
process of cost-push
inflation continues.
Cost-push inflation
occurred in the United
States during 1974–
1978.
43
Inflation
Inflation is always and everywhere a monetary
phenomenon
 The 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).
 This point is important because someone might ask, β€œCan’t
government purchases continually increase and so cause continued
inflation?” This is unlikely for two reasons.
Inflation
Inflation is always and everywhere a monetary
phenomenon
1. Government purchases cannot go beyond both real and political limits.
The real upper limit is 100 percent of GDP. No one knows what the
political upper limit is, but it is likely to be substantially less than 100
percent of GDP. In either case, once government purchases reach
their limit, they can no longer increase.
2. Some economists argue that government purchases that are not
financed with new money may crowd out one of the other expenditure
components. For example, for every additional dollar government
spends on public education, households may spend $1 less on private
education.
Inflation
Inflation is always and everywhere a monetary
phenomenon
The emphasis on the money supply as the only factor that can
continue to increase and thus cause continued inflation has led
most economists to agree with Nobel Laureate Milton Friedman
that β€œinflation is always and everywhere a monetary phenomenon.”
Inflation
Can You Get Rid of Inflation with Price Controls?
 Say, in country A, the government uses price control to stem
inflation. Price ceilings (price control mechanism) are always set
below equilibrium price.
 So, if the government has set up price ceiling say for good 𝑖 at $8
where the equilibrium price is $4 then there will be a shortage for
good 𝑖, and very likely, people will line up to buy it. Let’s say that, on
average, 25 people stand in line. If the price goes up to say $12 but
the price ceiling for the good remains set at $4, people will continue
to line up to buy the good, but now the lines will be longer. The
average line may stretch out to, say, 50 people.
 So how is inflation felt in a country that imposes and
maintains price ceilings? The answer is in the length of the lines of
people: the longer the lines, the higher the inflation rate.
Money and Interest Rates
What Economic Variables Does a Change in the Money
Supply Affect?
 Money supply can affect interest rates, but to understand how, we
need to review how the money supply affects different economic
variables.
 Changes in the money supply (or changes in the rate of growth of
the money supply) can affect:
1.
2.
3.
4.
The supply of loans.
Real GDP.
The price level.
The expected inflation rate.
Money and Interest Rates
What Economic Variables Does a Change in the Money
Supply Affect?
1. Money and the Supply of Loans
When the Central Bank (CB) undertakes an open market purchase
(buy government bonds from commercial banks), reserves in the
banking system increase. With greater reserves, banks can extend
more loans raising money supply. In other words, as a result of the
CB’s conducting an open market purchase, the supply of loans rises.
Similarly, when the Fed conducts an open market sale (sell government
bonds to commercial banks), the supply of loans decreases, i.e.,
money supply decreases. So, money supply and supply of loans go
hand in hand.
Money and Interest Rates
What Economic Variables Does a Change in the Money
Supply Affect?
2. Money and Real GDP
In the short run, an increase in the money supply shifts the AD curve
rightward increasing real GDP. Similarly, in the short run, a decrease in
the money supply produces a lower level of Real GDP
Money and Interest Rates
What Economic Variables Does a Change in the Money Supply
Affect?
3. Money and the Price Level
An increase in the money supply shifts the 𝐴𝐷 curve rightward from 𝐴𝐷1 to 𝐴𝐷2 .
In the short run, the price level in the economy moves from 𝑃1 to 𝑃2 . In the long
run, the economy is at point 3, and the price level is 𝑃3 . Panel (b) shows how a
decrease in the money supply affects the price level.
Money and Interest Rates
What Economic Variables Does a Change in the Money
Supply Affect?
4. Money and the Expected Inflation Rate
Many economists say that because the money supply affects the price
level, it also affects the expected inflation rate, which is the inflation rate
that you expect. Changes in the money supply affect the expected
inflation rate, either directly or indirectly. The equation of exchange
indicates that the greater the increase in the money supply is, the
greater the rise in the price level will be. And we would expect that the
greater the rise in the price level is, the higher the expected inflation
rate will be, ceteris paribus. For example, we would predict that a
money supply growth rate of, say, 10 percent a year generates a
greater actual inflation rate and a larger expected inflation rate than a
money supply growth rate of 2 percent a year.
Money and Interest Rates
The Money Supply, the
Loanable Funds Market, and
Interest Rates
The demand for loanable funds (𝐷𝐿𝐹 )
is downward sloping, indicating that
borrowers will borrow more funds as
the interest rate declines. The supply
of loanable funds (𝑆𝐿𝐹 ) is upward
sloping, indicating that lenders will
lend more funds as the interest rate
rises. The equilibrium interest rate (𝑖1 )
is determined through the forces of
supply and demand. If there is a
surplus of loanable funds, the interest
rate falls; if there is a shortage of
loanable funds, the interest rate rises.
Money and Interest Rates
The Money Supply, the Loanable Funds Market,
and Interest Rates
Anything that affects either the supply of or the demand for
loanable funds will obviously affect the interest rate. All four
of the factors that are affected by changes in the money
supplyβ€”the supply of loans, Real GDP, the price level, and
the expected inflation rateβ€”affect either the supply of or
demand for loanable funds.
Money and Interest Rates
The Money Supply, the
Loanable Funds Market,
and Interest Rates
The Supply of Loans:
A CB open market purchase
increases reserves in the banking
system and therefore increases the
supply of loanable funds. As a
result, the interest rate declines.
This change in the interest rate due
to a change in the supply of
loanable funds is called the
liquidity effect.
Money and Interest Rates
The Money Supply, the Loanable Funds Market, and
Interest Rates
Real GDP:
 A change in Real GDP affects both the supply of and the demand for
loanable funds. When Real GDP rises, people’s wealth is greater.
When people became wealthier, they often demand more bonds.
Demanding more bonds (buying more bonds), however, is nothing
more than lending more money to others. So, as Real GDP rises, the
supply of loanable funds increases.
 When Real GDP rises, profitable business opportunities arise all
around, and businesses issue or supply more bonds to take
advantage of those opportunities. But supplying more bonds is nothing
more than demanding more loanable funds. So, when Real GDP
rises, corporations issue or supply more bonds, thereby demanding
more loanable funds.
Money and Interest Rates
The Money Supply, the
Loanable Funds Market,
and Interest Rates
Real GDP:
In summary, when Real GDP
increases, both the supply of and
the demand for loanable funds
increase. 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.
Money and Interest Rates
The Money Supply, the
Loanable Funds Market,
and Interest Rates
The Price Level:
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.
Money and Interest Rates
The Money Supply, the Loanable Funds Market, and
Interest Rates
The Expected Inflation Rate:
Suppose the expected inflation rate is zero and that when the expected
inflation rate is zero, the equilibrium interest rate is 6%. Now suppose
the expected inflation rate rises from 0% to 4%. What will this rise in the
expected inflation rate do to the demand for and supply of loanable
funds?
As inflation is expected to rise in the future, households and firms will
want to buy more goods and services now, thus raising demand for
loanable funds β†’ 𝐷𝐿𝐹 shifts to the right.
Lenders on the other hand will know that if they lend today and price
level increases tomorrow then the money they will get back tomorrow
will have less value than today. Therefore, they will be willing to lend
each dollar (or taka) at higher interest rate β†’ 𝑆𝐿𝐹 shifts to the left.
Money and Interest Rates
The Money Supply, the
Loanable Funds Market,
and Interest Rates
The Expected Inflation Rate:
Thus an expected inflation rate of
4 percent increases the demand
for loanable funds and decreases
the supply of loanable funds. So
the interest rate is 4 percent higher
than it was when the expected
inflation rate was zero. A change in
the interest rate due to a change in
the expected inflation rate is
referred to as the expectations
effect or Fisher effect, after
economist Irving Fisher.
Money and Interest Rates
Money and Interest Rates
What Happens to the Interest Rate as the Money
Supply Changes?
Suppose:
 Point 1 in Time: CB says it will increase the growth rate of the
money supply.
 Point 2 in Time: If the expectations effect kicks in immediately,
then…
 Point 3 in Time: Interest rates rise.
At point 3 in time, a natural conclusion is that an increase in the rate of
growth in the money supply raises the interest rate. The problem with
this conclusion, though, is that not all the effects (liquidity, income, etc.)
have occurred yet.
Money and Interest Rates
What Happens to the Interest Rate as the Money
Supply Changes?
In time, the liquidity effect puts downward pressure on the interest rate.
Suppose,
 Point 4 in Time: Liquidity effect kicks in.
 Point 5 in Time: As a result of what happened at point 4, the interest
rate drops. The interest rate is now lower than it was at point 3.
Then, someone at point 5 in time could say, β€œObviously, an increase in
the rate of growth of the money supply lowers interest rates.”
The main idea is that a change in the money supply affects the
economy in many ways. The timing and magnitude of these effects
determine the changes in the interest rate.
Money and Interest Rates
The Nominal and Real Interest Rates
Nominal interest rate is the growth rate of your money whereas Real
interest rate is the growth rate of your purchasing power.
Fisher effect: Approximation
nominal interest rate = real interest rate + expected inflation rate
𝑖 = π‘Ÿ + πœ‹ or π‘Ÿ = 𝑖 βˆ’ πœ‹
Example: 𝑖 = 9%, πœ‹ = 6%
π‘Ÿ = 𝑖 – πœ‹ = 9% βˆ’ 6% = 3%
In words, the real rate of interest is the nominal rate reduced by the
loss of purchasing power resulting from inflation.
Money and Interest Rates
Fisher effect: Exact
Growth factor of your purchasing power, 1 + π‘Ÿ, equals the growth factor
of you money, 1 + 𝑖, divided by the new price level, that is, 1 + πœ‹ times
its value in the previous period. Therefore, the exact relationship would
be
1 + π‘Ÿ = (1 + 𝑖)/(1 + πœ‹)
π‘Ÿ = (𝑖 βˆ’ πœ‹) / (1 + πœ‹)
= (9% βˆ’ 6%) / (1.06)
= 2.83%
Empirical Relationship
Inflation and interest rates move closely together.