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Selman KaymazMONEY, THE PRICE LEVEL, AND INFLATION

Money is any commodity or token that is generally acceptable as a means of payment. A means of payment is a method of settling a debt. Money has three other functions:

Medium of exchange Unit of account Store of value

What is Money?

2Notes and teaching tips: 5, 8, 9, 13, 23, 29, 47, 67, and 70. To view a full-screen figure during a class, click the red expand button.To return to the previous slide, click the red shrink button.To advance to the next slide, click anywhere on the full screen figure.

1. Medium of ExchangeA medium of exchange is an object that is generally accepted in exchange for goods and services.In the absence of money, people would need to exchange goods and services directly, which is called barter.Barter requires a double coincidence of wants, which is rare, so barter is costly.

Unit of account A Unit of Account is an agreed measure for stating the prices of goods and services. 3.Store of ValueAs a store of value, money can be held for a time and later exchanged for goods and services.What is Money?

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What is Money?

The Money MarketThe Price LevelA rise in the price level increases the quantity of nominal money but doesnt change the quantity of real money that people plan to hold.Nominal money is the amount of money measured in dollars. Real money equals nominal money price level.The quantity of nominal money demanded is proportional to the price levela 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent.

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The Nominal Interest Rate The nominal interest rate is the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset.A rise in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold.Real GDPAn increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.

The Money Market

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Financial Innovation Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold.The Demand for MoneyThe demand for money is the relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same.

The Money Market

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Figure 8.4 illustrates the demand for money curve.A rise in the interest rate brings a decrease in the quantity of real money demanded.A fall in the interest rate brings an increase in the quantity of real money demanded.

The Money Market

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Shifts in the Demand for Money CurveFigure 8.5 shows that a decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward.An increase in real GDP increases the demand for money and shifts the demand curve rightward.

The Money Market

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Inflation

Some Basics about InflationInflation is a continuous rise in the price level and is measured with price indexesExpectations of inflation can become built into individuals behavior and economic institutions and cause a small inflation to accelerateInflation creates feelings of injustice and destroys the informational value of prices and the market16-13

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Expectations of InflationExpectations play a key role in the inflationary processRational expectations are the expectations that the economists models predictAdaptive expectations are expectations based in some way on the pastExtrapolative expectations are expectations that a trend will continue16-14

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Nominal Wages, Productivity, and InflationPrice levelReal outputSAS0AD

SAS1When nominal wages increase by more than the growth of productivity, the SAS curve shifts up, resulting in inflationWhen nominal wages increase by less than the growth of productivity, the SAS curve shifts down, resulting in deflationSAS116-15

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Theories of InflationThe two theories of inflation are the quantity theory and the institutional theoryThe quantity theory emphasizes the connection between money and inflation; if the money supply rises, the price level risesThe institutional theory emphasizes the relationship between market structure and price-setting institutions and inflationThe two theories overlap significantly, but because they come to different policy conclusions16-16

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Quantity Theory and the Inflation/Growth Trade-OffInflationGrowth

Quantity theorists emphasize the inflation/growth tradeoff16-17

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Inflation-video

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