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Classical Theory of Inflation
Quantity theory of money
Most economists today rely on this theory to explain the long-run determinants of the price level and the inflation rate.
Value of Money Equation
P is price level and measures the number of dollars needed to buy a basket of goods and services
turn this idea around: The quantity of goods and services that can be bought with $1 equals 1/P.
1/P is the value of money measured in terms of goods and services.
Ex. a cone costs $2, P=2
1/P, means the value of a collar is half a cone
When the overall price level rises, the value of money falls
Variable that affect the demand for money
the average level of prices in the economy
In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply (equilibirum)
If the price level is above the equilibrium level, people will want to hold more money than the Bank of Canada has created, so the price level must fall to balance supply and demand.
If the price level is below the equilibrium level, people will want to hold less money than the Bank of Canada has created, and the price level must rise to balance supply and demand.
Supply and Demand Curve for Money
Horizontal axis shows quantity of money
Left vertical shows the value of money 1/p
right vertical shows the price level P
Top, low level
Bottom, high level
When the value of money is high (as shown near the top of the left axis), the price level is low (as shown near the top of the right axis).
The supply curve is vertical because the Bank of Canada has fixed the quantity of money available.
The demand curve for money is downward sloping, indicating that when the value of money is low (and the price level is high), people demand a larger quantity of it to buy goods and services.
Equlibirum determines the value of money and the price level
Effects of Money Injection
Money injection shifts the supply curve to the right (from MS1 to MS2)
This move equilibrium from point A to B
Value of money (shown on the right) decreases from 2 to 4
In other words, when an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that makes each dollar less valuable.
Quantity Theory of Money
This explanation of how the price level is determined and why it might change over time
According to the quantity theory, the quantity of money available in the economy determines the value of money, and growth in the quantity of money is the primary cause of inflation.
Nominal variables
variables measured in monetary units.
Ex Nominal GDP
real variables
variables measured in physical units.
Ex. Real GDP
classical dichotomy
The seperatio of variables into real and nominal
Monetary Neutrality
This irrelevance of monetary changes for real variables in the long run
the proposition that changes in the money supply do not affect real variables
Classical Theory on Long Run Economy
Over the course of a decade, for instance, monetary changes have important effects on nominal variables (such as the price level) but only negligible effects on real variables (such as real GDP).
Monetary Neutrality is a good description of how the world works in terms of long ryn changes in the economy
Velocity of Money.
The rate at which money changes hands
The speed at which the typical dollar travels around the economy from wallet to wallet.
Calculating Velocity of Money
V=(PxY)/M
V: Velocity
P: Price Level (GDP Deflator)
Y: Quantity of output (Real GDP)
M: Quantity of Money
Quantity Equation
MxV=PxY
Rearranged velocity equation
V: Velocity
P: Price Level (GDP Deflator)
Y: Quantity of output (Real GDP)
M: Quantity of Money
Shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables:
The price level must rise,
the quantity of output must rise,
the velocity of money must fall.
Equilibirum Price Level and Inflation Explained
The velocity of money is relatively stable over time.
Because velocity is stable, when the quantity of money (M) changes, it causes proportionate changes in the nominal value of output (P×Y).
The economy’s output of goods and services (Y) is primarily determined by factor supplies (labour, physical capital, human capital, and natural resources) and the available production technology. In particular, because money is neutral, money does not affect output.
With output (Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P×Y) , these changes are reflected in changes in the price level (P).
Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.
inflation tax
the revenue the government raises by creating money
When the government prints money, the price level rises, and the dollars in your pocket are less valuable.
The inflation ends when the government institutes fiscal reforms—such as cuts in government spending—that eliminate the need for the inflation tax.
Real and Nominal Interest Rate Equation
Real = Nominal Interest Rate- Inflation Rate
Nominal= Real Interest Rate + Inflation rate
Fisher Effect
The one-for-one adjustment of the nominal interest rate to the inflation rate
When the Bank of Canada increases the rate of money growth, the result is both a higher inflation rate and a higher nominal interest rate.
Does not hold in the short run because inflation is unanticipated
The Inflation Fallacy
Believing that a rise in prices (inflation) means an equal loss in purchasing power
Costs of Inflation
Shoeleather Costs
Menu Costs
Relative-price Variability and the Misallocation of Resources
Inflation-Induced tax Distortions
Confusion and Inconvenience
Arbitrary Redistributions of Wealth
Shoeleather Costs
The cost of reducing your money holdings
The cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand than you would if there were no inflation.
The resources wasted when inflation encourages people to reduce their money holdings
the cost of time and effort that people spend trying to counteract the effects of inflation,
Menu Costs
The cost of price adjustments
Firms change prices infrequently because there are costs of changing prices
Include the cost of deciding on new prices, the cost of printing new price lists and catalogues, the cost of sending these new price lists and catalogues to dealers and customers, the cost of advertising the new prices, and even the cost of dealing with customer annoyance over price changes.
The more inflation rises, the more firms must change their prices which is costly
Relative-Price Variability and the Misallocation of Resources
Because prices change only once in a while, inflation causes relative prices to vary more than they otherwise would.
market economies rely on relative prices to allocate scarce resources.
Consumers decide what to buy by comparing the quality and prices of various goods and services.
When inflation distorts relative prices, consumer decisions are distorted, and markets are less able to allocate resources to their best use.
Inflatoin Induced Tax Distortions
lawmakers often fail to take inflation into account when writing the tax laws; economists who have studied the issue conclude that inflation tends to raise the tax burden on income earned from savings.
taxes already distorts buying incentives, and inflation makes this worse
higher inflation tends to discourage people from saving
Confusion and Inconvenience
When the Bank of Canada increases the money supply and creates inflation, it erodes the real value of the unit of account.
inflation makes investors less able to sort out successful from unsuccessful firms, which in turn impedes financial markets in their role of allocating the economy’s saving to alternative types of investment.
Arbitrary Redistributions of Wealth
Unexpected changes in prices redistribute wealth among debtors and creditors.
Inflation is especially volatile and uncertain when the average rate of inflation is high.
If a country pursues a high-inflation monetary policy, it will have to bear not only the costs of high expected inflation but also the arbitrary redistributions of wealth associated with unexpected inflation.
Friedman rule
rescription for moderate deflation
closed economy
an economy that does not interact with other economies.
open economy
an economy that interacts freely with other economies around the world
How an economy interacts with other economies
Buys and sells goods and services in world product markets
Buys and sells capital assets (ex. stocks and bonds)in world financial markets
Net Exports Equation
= Value of Country’s Exports - Value of Country’s Imports
Trade Balance aka Net Exports
the value of a nation’s exports minus the value of its imports
Trade Surplus
When a country exports more than it imports
Trade Deficit
When a country imports more than it exports
Balanced Trade
When Exports and Imports are equal
Net Exports are 0
Net Capital Outflow (NCO) (aka Net Foreign Investment)
The purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners
NCO= Purchase of foreign assets by domestic residents - Purchase of assets by foreigners
Negative means domestic residents are buying less foreign assets than foreigners are buying domestic assets
when net capital outflow is negative, a country is experiencing a capital inflow
Positive means domestic residents are buying more foreign assets than foreigners are buying domestic assets
Factors Affecting NCO
real interest rates being paid on foreign assets
real interest rates being paid on domestic assets
perceived economic and political risks of holding assets abroad
government policies that affect foreign ownership of domestic assets
NCO and NX Identity
NCO=NX
Net Capital Outflow and Net Exports must offset each other
When NX>0, NCO>0 and a nation is running a trade surplus
When NX<), NCO<0, and a nation is running a trade deficit
GDP Equation
y-C+I+G+NX
Y:GDP
C: Consumption
I: INvestment
G: Government Purchases
NX: Net Exports
National Savings Equation
Y-C-G= I-NX
S-I+NX
S=I+NCp also works because NX=NCO
(S=Y-C-G)
rearranged GDP equation
3 Outcomes for an Open Economy
Trade Deficit
Export<Imports
NX and NCO<0
Trade Surplus
Export>Imports
NX and NCO= 0
Balanced Trade
Exports=Imports
NX and NCO>0
Nominal Exchange Rate
the rate at which a person can trade the currency of one country for the currency of another
Ex. 80yen/CAD Is 1/80=0.0124 dollars per yen
appreciation of the dollar
An increase in the value of a currency as measured by the amount of foreign currency it can buy
If the exchange rate changes so that a dollar can buy more foreign currency
depreciation of the dollar.
A decrease in the value of a currency as measured by the amount of foreign currency it can buy
If the exchange rate changes so that a dollar can buy less foreign currency
CERI
The Canadian-dollar effective exchange-rate index (CERI) is a weighted average of the exchange rates between the Canadian dollar and the currencies of Canada’s major trading partners.
Real Exchange Rate
the rate at which a person can trade the goods and services of one country for the goods and services of another.
Real Exchange Rate Formula
= (Nominal Exchange Rate x Domestic Price)/Foreign Price
Purchasing-Power Parity.
a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries
Small Open Economy
An economy that trades goods and services with other economies and, by itself, has a negligible effect on world prices and interest rates
Perfect Capital Mobility
Full access to world financial markets
Canadians have full access to world financial markets and that people in the rest of the world have full access to the Canadian financial market.
Interest Rate Parity.
The theory that the real interest rate in Canada should equal that in the rest of the world
a theory of interest rate determination whereby the real interest rate on comparable financial assets should be the same in all economies with full access to world financial markets
Three Kay Facts About Economic Fluctuations
Fluctuations are Irregular and Unpredictable
Most Macroeconomic Quantities Fluctuation Together
As Output Falls, Unemployment Rises
Model of Aggregate Demand and Aggregate Supply
the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend
On the vertical axis is the overall price level in the economy.
On the horizontal axis is the overall quantity of goods and services.
aggregate-demand curve
A curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level
a fall in the economy’s overall level of prices tends to raise the quantity of goods and services demanded ad vice versa
Aggregate-Supply Curve
a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level
In the long run, the aggregate-supply curve is vertical, whereas in the short run, the aggregate-supply curve is upward sloping.
Why does the Demand Curve Slope Downwards
The Wealth Effect
The Real Exchange Rate
Interest Rate Effect
Wealth Effect
When the price level falls, the dollars you are holding rise in value, which increases your real wealth and your ability to buy goods and services.
A decrease in the price level makes consumers wealthier, which in turn encourages them to spend more.
The increase in consumer spending means a larger quantity of goods and services demanded.
and vice versa
Ex. One dollar is always worth one dollar. Yet the real value of a dollar is not fixed. If a candy bar costs one dollar, then a dollar is worth one candy bar. If the price of a candy bar falls to 50 cents, then one dollar is worth two candy bars
The Interest Rate Effect
A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded.
And vice versa
The Real Exchange-Rate Effect
A fall in the Canadian price level causes the real exchange rate to depreciate, and this depreciation stimulates Canadian net exports and thereby increases the quantity of goods and services demanded.
and vice versa
*GDP=C+I+G+NX
Why the aggregate demand curve might shift
Increases in expenditure shift the curve right
Decreases in expenditure shift the curve left
Increases in withdrawals shift left.
Decreases in withdrawals shift right.
If an injection increases or a withdrawal decreases
At each possible price level, there is a higher level of expenditure than before
If an injection decreases or a withdrawal increases
At each possible price level, there is a
Causes:
Changes in Consumption
Changes in Investment
Changes in Government Purchases
Changes in Net Exports
(Changes in I,X,G,C, not P)
Why is the Aggregate-Supply Curve Vertical in the Long Run
In the long run, an economy’s production of goods and services (its real GDP) depends on its supplies of labour, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.
Because the price level does not affect long-run determinants of real GDP, the long-run aggregate-supply curve is vertical,
Why the aggregate supply curve might shift
Shift to the right if there is an increase
Shift to the left if there is a decrease
Causes:
Changes in Labour
Changes in Capital
Changes in Natural Resources
Changes in Technological Knowledge
natural level of output
The production of goods and services that an economy achieves in the long run when unemployment is at its normal rate
Equilibrium of agregate curves
In short-run equilibrium, Aggregate Demand (AD) = Short-Run AggregTE SUPPLY (SRAS),
The planned expenditures of consumers, investors, etc. are consistent with the production plans of firms at the equilibrium P
Short Run Equilibrium
Long Run Equilibirum
Why does the Aggregate-Supply Curve Slope Upward in the Short Run
The quantity of output supplied deviates from its long-run, or “natural,” level when the actual price level deviates from the price level that people expected to prevail
When the price level rises above the expected level, output rises above its natural level, and when the price level falls below the expected level, output falls below its natural level.
Sticky Wage Theory
The Sticky-Wage Theory
According to this theory, the short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust to changing economic conditions.
In other words, wages are “sticky” in the short run.
As price increases, it’s more profitable to produce so GDP rises
Why the SRAS Curve Might Shift
Changes in labour, capital, natural resources, technological knowledge
Also, price level that people expect to prevail
When people change their expectations of the price level, the short-run aggregate supply curve shifts.
Ex. an increase in an economy capital stock will shift the curve right
An increases in minimum wage will shift the curve left
Steps for Analysing Macro Fluctuations
Decide whether the event shifts the aggregate-demand curve or the aggregate-supply curve (or perhaps both).
Decide in which direction the curve shifts.
Use the diagram of aggregate demand and aggregate supply to see how the shift changes output and the price level in the short run.
Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its long-run equilibrium.
Theory of Liquidity Preference
Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance
Money Supply Effects
The money supply is controlled by the Bank of Canada (BoC)
Supply of money is not affected by changes in the interest rate
Curve shifts right is there is an increase in the money supply
When supply shifts, so does demand because the shift in supply changes interest rates. Interest rate affects demand.
Money Demand Effects
The liquidity of money explains the demand for it: People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services.
Demand depends on interest rate
the interest rate is the opportunity cost of holding money.
An increase in the interest rate raises the cost of holding money and, as a result, reduces the quantity of money demanded.
A decrease in the interest rate reduces the cost of holding money and raises the quantity demanded
Shifts right if P of real GDP increase
Shifts left if P or real GDP decreases
Equilibrium in the Money Market
According to the theory of liquidity preference, the interest rate adjusts to balance the supply and demand for money.
If the interest rate is higher (r1), there is an excess supply of money,
Downward pressure on interest rates, causing the quantity demanded of money to rise, moving it back toward equilibrium quantity supplied
If the interest rate is lower (r2), there is excess demand for money,
upward pressure on interest rates, causing the quantity demanded of money to fall, moving it back toward equilibrium quantity supplied
Interest Rate Effect:
A higher price level raises money demand.
Higher money demand leads to a higher interest rate.
A higher interest rate reduces the quantity of goods and services demanded.
Shift in Supply Graph
When the Bank of Canada increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the right.
Conversely, when the Bank of Canada contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the left.
Flexible Exchange Rate
A policy by which the value of the exchange rate is allowed to vary without interference by the central bank
Expansionary monetary policy
Works by reducing interest rates and stimulating investment spending
The economy in a recessionary or a negative output gap
Contractionary Policy
Monetary measure to reduce government spending or the rate of monetary expansion by a central bank.
Restrictive monetary policy
Stabilisation Policy
Deliberate, conscious effort of the government to intervene in the macroeconomy with an eye toward influencing the course of Equilibrium P or Q (real GDP)
Fiscal policy
The setting of the level of government spending and taxation by government policymakers
Expansionary and Contractionary Fiscal Policy Shifts
Expansionary shitfs the AD curve right
Contractionary shifts the AD curve left
Multiplier Effect
The additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending
The basic idea is that if the government increases spending (which it is doing now big time), this increase in spending has an effect on AD that causes it to expand again and again
Ultimately by much more than the initial expansion of AD
Geometrically, it is the magnitude of the horizontal shift in AD
When consumer spending rises, the firms that produce these consumer goods hire more people and experience higher profits.
Higher earnings and profits stimulate consumer spending once again, and so on.
Thus, there is positive feedback as higher demand leads to higher income, which in turn leads to even higher demand
Interpretation: the change in total spending (C + I + G + NX) which results from a $1 change in government spending.
The higher (lower) the multiplier, the greater (lesser) the response
Formula for the Spending Multiplier
Value of multiplier = Δ aggregate expenditure /Δ G
MPC: marginal propensity to consume
The fraction of extra income that a household consumes rather than saves
Ex. For example, suppose that the marginal propensity to consume is
3/4. This means that for every extra dollar that a household earns, the household spends $0.75 (3/4 of the dollar) and saves $0.25
With an MPC of 3/4, when the workers and owners of the construction firms earn $5 billion from the government contract, they increase their consumer spending by 3/4×$5billion, or $3.75 billion.
This goes on. Becomes MPC×(MPC×$5billion). These feedback effects go on and on.
Multiplier = (1 + MPC + MPC 2+ MPC3 + …) x 5 billion
Multiplier= 1/(1-MPC)
The government-spending multiplier tells us the demand for Canadian-produced goods and services generated by each additional dollar of government expenditure.
marginal propensity to import (MPI)
The relevant formula for the government-purchases multiplier in an open economy is:
Multiplier= 1/(1-MPC+MPI)
The Crowding-Out Effect on Investment
The offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending
In the OUTPUT market, the increase in G, amplified by the multiplier effect, results in a new equilibrium with an increase in both P and real GDP
In the MONEY market, these changes cause an expansion in the demand for money, resulting in an increase in the equilibrium interest rate
Back in the OUTPUT market, this increase in the interest rate causes a decrease in I spending, which causes a leftward shift in the AD curve
This is the ‘crowding out’ part
Net effect: the impact of the fiscal stimulus is partially OFFSET but probably not by 100 %
When the government increases its purchases by $5 billion, the aggregate demand for goods and services could rise by more or less than $5 billion, depending on whether the multiplier effect or the crowding-out effect on investment is larger. The crowding-out effect pushes the aggregate-demand curve in the opposite direction and, if large enough, could result in an aggregate-demand shift of less than $5 billion
Crowding Out Effect Open Economy
In the OUTPUT market, the increase in G, amplified by the multiplier effect, results in a new equilibrium with an increase in both P and real GDP
In the MONEY market, these changes cause an expansion in the demand for money, resulting in an increase in the equilibrium interest rate
Back in the OUTPUT market, this appreciation in the Canadian $ causes a decrease in NX spending, which causes a leftward shift in the AD curve
This is the ‘crowding out’ part
Net effect: this instance of crowding out can amplify the other case (involving I spending), and further OFFSET the fiscal stimulus
In a small open economy, an expansionary fiscal policy causes the dollar to appreciate. Because this appreciation of the dollar causes net exports to fall, there is an additional crowding-out effect that reduces the demand for Canadian-produced goods and services. In the end, fiscal policy has no lasting effect on aggregate demand.
crowding-out effect on net exports
The offset in aggregate demand that results when expansionary fiscal policy in a small open economy with a flexible exchange rate raises the real exchange rate and thereby reduces net exports
Automatic Stabilizer
Fiscal policy that is built into the government’s tax and expenditure apparatus that self-activates
Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession, without policymakers having to take any deliberate action
Tax system, Government Spending:
When in a recession, UI payments increase and total tax revenue decreases
AD shifts rights. But not sufficient to bring about an end to the recession
When beyond potential GDP, UI payments decrease and total tax revenue increases
AD shifts left.
Deficits and debt
Fiscal Deficit = T – G < 0
Fiscal Surplus = T – G > 0
Both quantities typically expressed as a share of GDP, as GDP (= aggregate income) is the means to repay it.
Deficits are financed by issuing government bonds
Debt vs Deficit Definitions
Debt is a STOCK quantity referring to total amount owed
No time frame
Sum of all prior deficits and surpluses
Deficit is a FLOW quantity referring to shortfall PER TIME PERIOD
Benefits of debt-financed deficits
VERY politically popular because it’s “free extra spending”
Actually, it is not
Address negative AD and/or SRAS shocks
Can finance investments in infrastructure that increase AS in both the short-run and the long-run
If it’s PRODUCTIVE public investment
Costs of debt-financing
Payment of interest
Re-payment of principal
Future generations only are affected
Crowding-out of private investment spending
Note 
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