MGI

What do most economists believe about the QTM?

What do most economists believe about the QTM?

the QTM is a good explanation of the long-run behavior of inflation

P

Price Level

What does inflation do to money?

Drives up prices and drives down the value of money.

Who developed the Quantity Theory of Money?

18th century philosopher David Hume and the classical economists

What does the QTM assert?

that the quantity of money determines the value of money

How is the QTM studied?

Supply-Demand Diagram, an equation

Who determines the Money Supply in the real world?

the fed, banking system, and consumers

Money Demand refers to…

how much wealth people want to hold in liquid form

An increase in P

reduces the value of money, so more money is required to buy g&s

1/P

Value of Money

Nominal variables

measured in monetary units

Real variables

measured in physical units

relative price

the price of one good relative to (divided by) another

real wage

W (nominal wage)/P (price level)

Classical dichotomy

the theoretical separation of nominal and real variables

Hume and the classical economists suggested that

monetary developments affect nominal variables but not real variables

If central bank doubles the money supply, Hume & classical thinkers contend all nominal variables

—including prices—will double

If central bank doubles the money supply, Hume & classical thinkers contend all real variables

—including relative prices—will remain unchanged

Monetary neutrality

the proposition that changes in the money supply do not affect real variables

the real wage W/P remains unchanged, so

quantity of labor supplied & demanded does not change,total employment of labor does not change

Most economists believe the classical dichotomy and neutrality of money

describe the economy in the long run.

Velocity of money

the rate at which money changes hands

Nominal GDP

P*Y

M

money supply

V

Velocity

Velocity formula

V=YP/M

Quantity equation

MV=PY

Percentage change

(End-Start)/Start

If real GDP is constant, then

inflation rate = money growth rate

If real GDP is growing, then

inflation rate < money growth rate

Economic growth increases

# of transactions

Some money growth is

needed for these extra transactions

Excessive money growth

causes inflation

Hyperinflation

generally defined as inflation exceeding 50% per month

Excessive growth in the money supply

always causes hyperinflation

Large govt budget deficits led to the creation of

large quantities of money and high inflation rates

When tax revenue is inadequate and ability to borrow is limited

govt may print money to pay for its spending

inflation tax

printing money causes inflation, which is like a tax on everyone who holds money

In the U.S., the inflation tax today accounts for

less than 3% of total revenue

Fisher effect

an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate (on wealth) is unchanged

The inflation tax applies to people’s holdings of money

not their holdings of wealth

inflation fallacy

most people think inflation erodes real incomes

Shoeleather costs

the resources wasted when inflation encourages people to reduce their money holdings

What does shoeleather costs include?

the time and transactions costs of more frequent bank withdrawals

Menu costs

the costs of changing prices (printing new menus, mailing new catalogs, etc.)

Misallocation of resources from relative-price variability

Firms don’t all raise prices at the same time, so relative prices can vary, which distorts the allocation of resources

Confusion & inconvenience

**Inflation changes the yardstick we use to measure transactions (**Complicates long-range planning and the comparison of dollar amounts over time)

Tax distortions

Inflation makes nominal income grow faster than real income

Taxes are based on

nominal income, and some are not adjusted for inflation

inflation causes people to

pay more taxes even when their real incomes don’t increase

Real IR= Nominal IR-Inflation

Nominal IR-Inflation

Nominal IR=

(% paid in decimal)*Nom. IR

We saw that money is neutral in

the long run, affecting only nominal variables