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Money Supply, Money Supply, Inflation, and Inflation, and
UnemploymentUnemployment
The Equation of The Equation of ExchangeExchange
MV = PYMV = PY
So…So…
%%ΔΔM + M + %%ΔΔV ≅ V ≅ %%ΔΔP + P + %%ΔΔYY
M = Money SupplyM = Money Supply V = Money VelocityV = Money Velocity P = Price LevelP = Price Level Y = real GDPY = real GDP
Inflation Rate in Long Inflation Rate in Long RunRun
Since Velocity tends to remain culturally constant, Since Velocity tends to remain culturally constant,
%%ΔΔM + 0 ≅ M + 0 ≅ %%ΔΔP + P + %%ΔΔY Y
OrOr
%%ΔΔM ≅ M ≅ %%ΔΔP + P + %%ΔΔY Y
Or, to understand inflation…Or, to understand inflation…
%%ΔΔP ≅ P ≅ %%ΔΔM — M — %%ΔΔYY
M = Money SupplyM = Money Supply V = Money VelocityV = Money Velocity P = Price LevelP = Price Level Y = real GDPY = real GDP
LRAS and InflationLRAS and Inflation
This explains why the European Central Bank This explains why the European Central Bank focuses their analysis on money supplyfocuses their analysis on money supply
If rGDP grows by 2 or 3% per year, then %If rGDP grows by 2 or 3% per year, then %ΔΔM M reliably determines inflationreliably determines inflation
%%ΔΔP ≅ P ≅ %%ΔΔM — M — %%ΔΔYY%%ΔΔP ≅ P ≅ %%ΔΔM — 3M — 3%%
M = Money SupplyM = Money Supply V = Money VelocityV = Money Velocity P = Price LevelP = Price Level Y = real GDPY = real GDP
Unemployment: Unemployment: Reservation WageReservation Wage
Employees want the Employees want the highest wage highest wage possiblepossible
Employers generally Employers generally want to pay the want to pay the least required (but least required (but not always)not always)
As time unemployed As time unemployed lengthens, lengthens, employees are employees are willing to take lower willing to take lower wages, but are wages, but are likely to find higher likely to find higher wage possibilitieswage possibilities
US Unemployment RateUS Unemployment Rate
Unemployment: Unemployment: Reservation WageReservation Wage
Government Government policy can policy can affect wages affect wages and and unemployment unemployment durationduration
Welfare and Welfare and unemployment unemployment relief payments relief payments extend durationextend duration
Effect on wages Effect on wages and duration?and duration?
RW1RW2
Wage
Duration of Search
BOR
Unemployment: Unemployment: Reservation WageReservation Wage
Faster and more Faster and more complete spread complete spread of information can of information can lead to higher BoRlead to higher BoR
Monster.com and Monster.com and other Internet other Internet sites increase job sites increase job vacancy vacancy awarenessawareness
Effect on wages Effect on wages and duration?and duration?
RW2
Wage
Duration of Search
BOR1BOR2
Unemployment: Unemployment: Reservation WageReservation Wage
What is the What is the effect of the effect of the comb-ination of comb-ination of unemployment unemployment payment policy payment policy and increased and increased spread of spread of information?information?
Effect on wages Effect on wages and duration?and duration?
RW2
Wage
Duration of Search
BOR2 BOR1
RW1
Scenario 1Scenario 1 The government, The government,
faced with rising faced with rising budget deficits, budget deficits, decides to limit decides to limit unemployment unemployment payments to only 4 payments to only 4 weeks.weeks.
What is the effect What is the effect on output, rGDP, on output, rGDP, and Price Level? and Price Level? (Use which graph?)(Use which graph?)
What is the likely What is the likely effect on wages effect on wages and the typical and the typical duration of search duration of search for a worker?for a worker?
AD2AD1
PL
rGDP
SRAS
RW2RW1
Wage
Duration of Search
BOR
Scenario 2Scenario 2 ECB statistics show ECB statistics show
that the money that the money supply is increasing supply is increasing by 8%. rGDP is by 8%. rGDP is increasing by 3%.increasing by 3%.
What is the expected What is the expected inflation rate?inflation rate?
What monetary What monetary policy should the policy should the ECB take to redress ECB take to redress the situation?the situation?
What effect will this What effect will this policy have on the policy have on the value of the US dollar value of the US dollar relative to the euro?relative to the euro?
D2D1
Exchange R
ate of Dollar in E
uros
Q of $
S1 S1
MD
Real Interest R
ate
Q of $
MS1MS2
r1
r2