3.

The Economy in the long run: Money and Inflation

1. The Quantity Theory of Money linking the to the M (since T and Y are fixed)
The quantity equation
M*V = P*T
V = velocity
PT = value of all transactions = PY
M = money supply

Money demand function

k = 1/V

When people hold lots of money relative to their

income (k is high), money changes hand
infrequently (V is low)

( M / Pd kY
k = how
much money people wish to hold for
each dollar of income

Now, lets assumes that V is constant & V

V exogenous
M *V P * Y

MMV PPY Y

M
M
V P P Y Y

MP Y

M P Y
The Quantity Theory of Money predicts a oneM
Y
for-one relation between and .
M
Y

2. The Fisher Effect

The Fisher equation

i r
determines r, an

Since S = I
increase in causes an equal increase in i.
This one-for-one relationship is called
Fisher Effect.

d
The Quantity Theory of Money assumes M / P
that depends only on Y.
We now consider another
i (M/P) d

inflation
=actual
rate
=expected e inflation
rate
=ex ante i real
interest
rate
e post real
=ex
i
interest
rate

determinant: the nominal interest rate

3. The money demand function
depends negatively on i
( M / (PM) d / P )Ld(i, Y )
and positively on Y.
The nominal interest rate
( M / P ) d rL(er e , Y )
relevant for money demand is .
Variable

How determined (in the long run)

Exogenous (the ECB)

Adjusted to make S=I

Y F (K , L )
( M / P ) d L(i, Y ) Adjusted to

Y
P

make

How P responds to

M
L( r e , Y )
P
For given values of r, Y, and , a change in M e causes P to change by the same
percentage, just like in the Quantity

Theory of Money.

What about expected inflation?

Over the long run, on average.
e
In the short run, may change when
e people get new information.
EX: Suppose Fed announces it will increase
M next year. People will expect next years P
to
be higher, so rises. This will affect P now, e even though M hasnt changed yet.
* Positive relationship between inflation and the money growth
* Similar trends inflation rate & nominal interest rate
How P responds to

M
L( r e , Y )
P
For given values of r, Y, and M,
(the Fisher effect)

e i
( M / P ) d
(
M / P)

to make fall to re-establish the

equilibrium
4. The Classical Dichotomy
Real variable are measured in physical units:quantities and relative prices.
Nominal variables are measured in money units.
Classical Dichotomy : nominal variables do not affect real variables.
Neutrality of Money : Changes in the money supply do not affect real variables.

In the real world, money is approximately neutral in the long run.

5. Why is inflation bad?

Common misperception:
inflation reduces real wages is true only in the short run, when nominal wages are fixed
by contracts. In the long run, the real wage is determined by labor supply and the marginal
product of labor, not the price level or inflation rate.