MACROECONOMICS

Effects of Inflation

 Correcting Economic Variables for the Effects

of Inflation
 Turning dollar figures from year T into today’s
dollars

 CPI measures the price level and determines the

size of the inflation correction.
Regional differences in the cost of
living in U.S

 Effects of Inflation
 Indexation
 the automatic correction by law or contract of a dollar
amount for the effects of inflation
 Cost-of-living allowance (or COLA), automatically

raises the wage when the CPI

rises.
 Social Security benefits
 adjusted every year to compensate the elderly for increases
in prices.
 The brackets of the federal income tax—the income levels at

which the tax rates change

 Effects of Inflation

 Real and Nominal Interest Rates

 Interest rate involves comparing amounts of
money at different points in time.
 Deposit savings into bank => returns deposit

with interest in the future.

 Borrow from a bank => get money now =>

repay the loan with interest in the future.

 Future dollars have a different value than

today’s dollars => Inflation

 Effects of Inflation

 Example: Sara deposit $1,000 into bank

with 10% annual interest rate => Sara
will get 1,100 after 1 year
 Zero inflation
 Six percent inflation

 Ten percent inflation

 Twelve percent inflation

 Two percent deflation

 Effects of Inflation

 nominal interest rate

 theinterest rate as usually reported without
a correction for the effects of inflation
 Real interest rate
 the interest rate corrected for the effects of
inflation
U.S Real and Nominal Interest
Rates
The Classical Theory of Inflation
 The Level of Prices and the Value of money
 consumer price index (CPI) rise => many individual prices
that make up these price indexes => price level as the
price of a basket of
goods and services.
 When the price level rises =>people have to pay

more for the goods and services.

 Price level as a measure of the value of money => A rise

in the price level => lower value of money

 Effects of Inflation
 Money Supply, Money Demand, and Monetary
Equilibrium
 Money supply
 Federal Reserve, together with the banking system,
determines the supply of money.
 Fed sells bonds in open-market operations, it receives dollars

in exchange and contracts the money supply.

 When the Fed buys government bonds, it pays out dollars

and expands the money supply.

 Dollars are deposited in banks, which hold some as reserves

and loan out the rest

 Effects of Inflation
 Money Supply, Money Demand, and Monetary
Equilibrium
 Money demand
 The demand for money => how much wealth people want to
hold in liquid form.
 Factors influence the quantity of money demanded: The
amount of currency that people hold in their wallets, how much
they rely on credit cards and how easily they can find an
automatic teller machine.
 The quantity of money demanded depends on the interest rate
from buying an interest-bearing bonds, not in wallet or low-
interest checking account.
 Important variables affect the demand for money: the average
level of prices in the economy.
 Effects of Inflation
 Money Supply, Money Demand, and Monetary
Equilibrium
 Money demand
 People because it is the medium of exchange.
 Money has higher liquidity level than bonds or stocks =>

How much money to hold depends on the prices of goods

and services => The higher prices => more money the
typical transaction requires => more money people will
choose to hold in their wallets, checking accounts
 Higher price level increases the quantity of money

demanded.

 Effects of Inflation
 Money Supply, Money Demand, and Monetary
Equilibrium
 Money demand
 What ensures that the quantity of money the Fed supplies
balances the quantity of money people demand?
 Time horizon: short-run answer depends on

interest rates vs long-run answer could be equilibrium by the

overall level of prices.
 If the price level is above the equilibrium level => people hold more money
than the Fed has created => 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 Fed has created => price level must rise to balance supply
and demand
How the Supply and Demand for Money
Determine the Equilibrium Price Level
 Effects of Inflation

 The Effects of a Monetary Injection

 Imaging: Fed doubles the supply of money
by printing some dollar bills and dropping
them around the country from helicopters.
(Or by buying some government bonds from
the public in open-market operations.)
An Increase in the Money Supply

 Effects of Inflation

 Quantity theory of money

a theory asserting that the quantity of money
available determines the price level and that
the growth rate in the quantity of money
available determines the inflation rate
 The Classical Dichotomy and
Monetary Neutrality
 How do monetary changes affect other
variables, such as production, employment, real wages,
and real interest rates?
 Nominal variables
 variables measured in monetary units (in dollars)
 Real variables
 variables measured in physical units (in output)
The Classical Dichotomy and
Monetary Neutrality
 Classical dichotomy the theoretical
 Separation of nominal variables and real variables
 Example:
 Real wage (in dollars adjusted for inflation) is a real
variable because it measures the rate at which people
exchange goods and services for a unit of labor.
 Real interest rate (nominal interest rate adjusted for

inflation) is a real variable because it measures the

rate at which people exchange goods and services
today for goods and services in the future.
 The Classical Dichotomy and
Monetary Neutrality
 Why separate variables into these groups?
 Different forces influence real and nominal variables.
 Nominal variables are influenced by economy’s

monetary system vs real variables are not.

 Economy’s production of goods and services depends on technology

and factor supplies

 Real interest rate balances the supply and

demand for loanable funds

 Real wage balances the supply and demand for labor

 Unemployment exist when real wage above the equilibrium level.

 Not affecting quantity of money supplied.

 The Classical Dichotomy and
Monetary Neutrality
 Monetary neutrality
 the proposition that changes in the money
supply do not affect real variables
 Changes in the supply of money, affect nominal variables

but not real ones.

 When central bank doubles the money supply => price

level doubles => dollar wage doubles => all other dollar
values double.
 Real variables: production, employment, real wages, and

real interest rates unchanged.

The Classical Dichotomy and
Monetary Neutrality
 Monetary neutrality
 Money is the yardstick to measure
economic transactions
 When central bank doubles the money

supply => all prices double =>value of the

unit of account falls by half
 Dollars, like the yard, is merely a unit of

measurement, so a change in its value

should not have real effects.
The Classical Dichotomy and
Monetary Neutrality
 Monetary neutrality
 Is monetary neutrality realistic?
 Short periods of time (1- 2 years) => monetary
changes affect real variables.
 Over the course of a decade, monetary changes have

significant effects on nominal variables (such as the

price level) but only negligible effects on real variables
(such as real GDP).
 => Long-run changes in the economy, the neutrality of

money offers a good description of how the world

works.
 Velocity and the Quantity
Equation
 Velocity of money
 Rate at which money changes hands
 Velocity of money refers to the speed at which the typical

dollar bill travels around the economy from wallet to wallet.

 To calculating, we divide the nominal value of output

(nominal GDP) by the quantity of money.

 P is the price level (the GDP deflator), Y the

quantity of output (real GDP), and M the quantity of money

 Velocity and the Quantity
Equation
 Velocity of money
 Suppose that the economy produces 100
pizzas in a year, that a pizza sells for $10,
and that the quantity of money in the
economy is $50 => the velocity of money is
Velocity and the Quantity equation

 Quantity equation
 The equation relates the quantity of money, the velocity of
money, and the dollar
value of the economy’s output of goods and
services

V is the velocity of money, P is the price level (the GDP

deflator), Y the quantity of output (real GDP), and M the
quantity of money
U.S Nominal GDP, the Quantity of
Money, and the Velocity of Money

 Effects of Inflation
 The velocity of money is stable over time.
 When the central bank changes the quantity of money (M), it causes
proportionate changes in the nominal value of output
(P x Y).
 The economy’s output of goods and services (Y) is determined by factor
supplies (labor, physical capital, human capital, and natural resources) and
the available production technology.
 Because money is neutral, money does not affect output.
 Because output (Y) is fixed by factor supplies and technology => central
bank change money supply (M) and induces a proportional change in the
nominal value of output (P x Y) => reflected in a change in the price level (P).
 When the central bank increases the money supply => high rate of inflation.
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