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Chapter 9: Money, The Price Level, and Interest Rates

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The money supply (M) multiplied by its Velocity (V) must be equal to the price ... between the equation of exchange and the simple quantity theory of money? ... – PowerPoint PPT presentation

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Title: Chapter 9: Money, The Price Level, and Interest Rates


1
Chapter 9 Money, The Price Level, and
Interest Rates
2
Circular Flow Diagram
Flow of dollars
3
Money and the Price Level
  • Equation of Exchange MV ? PQ
  • The money supply (M) multiplied by its Velocity
    (V) must be equal to the price level (P) times
    Real GDP (Q).
  • Velocity the average number of times a dollar
    is spent to buy final goods and services in a
    year.

4
The Equation of Exchange
  • In a large economy, it is impossible to count how
    many times each dollar has changed hands.
  • Velocity must be equal to GDP divided by the
    average money supply.
  • VNominal GDP/Money supply
  • VGDP/M (in the textbook)
  • Nominal GDP is equal to PxQ, where Q is the
    quantity of GDP produced in the economy and is
    measured by Real GDP.

5
Interpreting the Equation of Exchange
  • V(PxQ)/M ? MVPxQ
  • The money supply multiplied by velocity must
    equal the price level times Real GDP M x V ? P x
    Q
  • The money supply multiplied by velocity must
    equal Nominal GDP M x V ? NGDP
  • Total spending or expenditures (measured by MV)
    must equal the total sales revenues of business
    firms (measured by PQ) MV ? PQ

6
Interpreting the Equation of Exchange
  • Equation of Exchange
  • MxVPxQ
  • M Money Supply
  • V Velocity
  • P Price Level (GDP deflator or CPI)
  • Q Real GDP
  • PxQ Nominal GDP

7
From the Equation of Exchange to the Simple
Quantity Theory of Money
  • Fisher and Marshall assumed changes in velocity
    are so small that for all practical purposes
    velocity can be assumed to be constant.
  • Fisher and Marshall assumed Real GDP is fixed in
    the short run.
  • From these assumptions, we have the simple
    quantity theory of money changes in M will bring
    about proportional changes in P.

8
From the Equation of Exchange to the Simple
Quantity Theory of Money
Notation ? means change
9
Exhibit 1 Assumptions and Predictions of the
Simple Quantity Theory of Money
10
Exhibit 1 Assumptions and Predictions of the
Simple Quantity Theory of Money
change in M or ?M is calculated as follows
Same is true for P change in P or ?P is
calculated as follows
11
The Simple Quantity Theory in an AD-AS Framework
  • MV is equal to Total Expenditures (AD).
  • Total expenditures is equal to
  • CIG(EX-IM)
  • Since MVTE, MVCIG(EX-IM)
  • A change in the money supply or a change in
    velocity will change aggregate demand and
    therefore lead to a shift in the AD curve.
  • In the simple quantity theory of money, velocity
    is assumed to be constant.

12
Exhibit 3 The Simple Quantity Theory in an
AD-AS Framework
13
Dropping the Assumptions that V and Q are Constant
  • Remember M x V ? P x Q, then
  • P M x V
  • Q
  • Money supply, velocity, and Real GDP determine
    the Price Level.
  • An increase in M or V or a decrease in Q will
    cause prices to rise. This is inflation.
  • A decrease in M or V or an increase in Q will
    cause prices to fall. This is deflation.

14
Self-Test
  • If M times V increases, why does P times Q have
    to rise?
  • What is the difference between the equation of
    exchange and the simple quantity theory of money?
  • Predict what will happen to the AD curve as a
    result of each of the following
  • The money supply rises, velocity is unchanged
  • Velocity falls, MS is unchanged
  • The money supply rises by a greater percentage
    than velocity falls
  • The money supply falls, velocity is unchanged.

15
Monetarism Key Views
  • 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)

16
Exhibit 4 Monetarism in an AD-AS Framework
17
The Monetarist View of the Economy
  • 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.

18
The Monetarist View of the Economy
  • 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
    therefore changes in Real GDP and the price
    level.
  • An increase in the money supply will raise
    aggregate demand and increase both Real GDP and
    the price level in the short run and increase the
    price level in the long run.
  • A decrease in the money supply will lower
    aggregate demand and decrease both Real GDP and
    price level in the short run and decrease price
    level in the long run.

19
Self-Test
  • What do monetarists predict will happen in the
    short run and in the long run as a result of each
    of the following
  • Velocity rises
  • Velocity falls
  • The money supply rises
  • The money supply falls.
  • Can a change in velocity offset a change in the
    money supply (on aggregate demand)? Explain your
    answer.

20
Money and Interest Rates What economic variables
are affected by a change in the money supply?
  • The supply of loans.
  • Real GDP
  • The price level
  • The expected inflation rate.

21
Money and Interest Rates
  • A change in the money supply creates a change in
    interest rates due to a change in
  • Liquidity Effect the supply of loanable funds.
  • Income Effect Real GDP.
  • Price Level Effect the price level.
  • Expectations Effect the expected inflation
    rate.

22
Money and Interest Rates
  • Liquidity Effect The change in the interest
    rate due to a change in the supply of loanable
    funds.
  • Money supply increase, increases reserves in the
    banks and shifts to the right supply of loanable
    funds. Interest rate declines.
  • Income Effect Change in interest rate due to
    the change in Real GDP.
  • Money supply increase, shifts AD to right
    increasing Real GDP. Real GDP increase increases
    both the supply and demand of loanable funds.
    Demand usually increases more than supply
    resulting in increase of interest rate.

23
Money and Interest Rates
  • Price Level Effect The change in the interest
    rate due to a change in price level.
  • Increase in money supply shifts AD to right
    increasing price level. Increase in price level
    decreases purchasing power of money. As a result
    people increase demand for loanable funds.
    Interest rate goes up.
  • Expectations Effect The change in interest rate
    due to a change in the expected inflation rate.
  • When Fed announces increase in money supply
    people will expect increase in price level. Thus
    they expect inflation rate to increase. It will
    increase demand for loanable funds and decrease
    supply of loanable funds and will increase
    interest rate.

24
Exhibit 5 The Interest Rate and the Loanable
Funds Market
25
Exhibit 6 How the Fed Affects the Interest Rate
26
What Happens to the Interest Rate as the Money
Supply Changes?
  • Change in Money Supply changes
  • Supply of loanable funds
  • Real GDP
  • The price level
  • Expected Inflation
  • Net impact on Interest Rate dependent on
  • Timing
  • Magnitudes

27
The Nominal and Real Interest Rates
  • Nominal interest rate the interest rate
    actually charged (or paid) in the market the
    market interest rate.
  • The Real Interest Rate the Nominal Interest
    Rate minus the Expected Inflation Rate.
  • Real interest rateNominal interest rate
    Expected Inflation rate
  • or
  • Nominal interest rateReal interest rate
    Expected Inflation rate

28
Self-Test
  • If the expected inflation rate is 4 and the
    nominal interest rate is 7, what is the real
    interest rate?
  • Is it possible for the nominal interest rate to
    immediately rise following an increase in the
    money supply? Explain your answer.
  • The Fed only affects the interest rate via the
    liquidity effect. Do you agree or disagree?
    Explain your answer.
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