Institute of International Education 3 2 Money Growth and Inflation •How does the money supply affect inflation and nominal interest rates? •Does the money supply affect real variables like real GDP o[.]
3.2 Money Growth and Inflation •How does the money supply affect inflation and nominal interest rates? •Does the money supply affect real variables like real GDP or the real interest rate? •How is inflation like a tax? •What are the costs of inflation? How serious are they? Institute of International Education Inflation Inflation is an increase in the overall level of prices Institute of International Education The Quantity Theory of Money ▪ Is used to explain determinants of the price level and the inflation rate ▪ Asserts that the quantity of money determines the value of money ▪ We study this theory using two approaches: A supply-demand diagram An equation Institute of International Education The Value of Money ▪ P = the price level (measured by the CPI or the GDP deflator ▪ P is the price of goods and services measured in terms of money; and… 1/P is the value of $1, measured in goods ➔ Inflation drives up prices and drives down the value of money Institute of International Education Money Supply (MS) ▪ In US, MS determined by Federal Reserve, the banking system - Through instruments such as open-market operations, the Fed directly controls the quantity of MS ▪ In this model, we assume the Fed precisely controls MS and sets it at some fixed amount Institute of International Education Money Demand (MD) ▪ Has several determinants, including interest rates and the average level of prices in the economy ▪ An increase in P reduces the value of money, so more money is required to buy g&s ▪ Quantity of MD is negatively related to the value of money and positively related to P, other things equal Institute of International Education Money Supply, Money Demand, and Monetary Equilibrium In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply Institute of International Education The Money Supply-Demand Diagram Value of Money, 1/P As the value of money rises, the price level falls Price Level, P ắ 1.33 ẵ ẳ Quantity of Money Institute of International Education The Money Supply-Demand Diagram Value of Money, 1/P A fall in value of money MS1 increases the quantity of money demanded: ắ ẵ Price Level, P The Fed sets MS at some fixed value, regardless of P ¼ 1.33 MD1 $1000 Institute of International Education Quantity of Money The Money Supply-Demand Diagram Value of Money, 1/P MS1 eq’m value of money P adjusts to equate quantity of money demanded with money supply A ¼ MD1 $1000 Institute of International Education 1.33 ắ ẵ Price Level, P eqm price level Quantity of Money ... The Money Supply-Demand Diagram Value of Money, 1/P As the value of money rises, the price level falls Price Level, P ắ 1 .33 ẵ ẳ Quantity of Money Institute of International Education The Money. .. International Education Quantity of Money The Money Supply-Demand Diagram Value of Money, 1/P MS1 eq’m value of money P adjusts to equate quantity of money demanded with money supply A ¼ MD1 $1000 Institute... Supply-Demand Diagram Value of Money, 1/P A fall in value of money MS1 increases the quantity of money demanded: ắ ẵ Price Level, P The Fed sets MS at some fixed value, regardless of P ¼ 1 .33 MD1