1

MacroLecture11
Money, The Price Level, and Inflation
Lecture Highlights
What determines the DD for money and how the DD
for money and the SS of money determine the
nominal interest rate.
In the long run, the quantity of money determines the
price level and money growth brings inflation.
The costs of inflation and the benefits of a stable
value of money.
The short-run trade off between inflation and
unemployment.
Distinguish between the short-run and the long-run
Phillips curves.
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Money, The Price Level, and Inflation
The price level and real GDP have resulted from
previous decisions. When the CB conducts an OMO
to change the qty of money, the nominal interest rate
is free to adjust until Md = Ms.
Changes in the nominal interest rate also change the
real interest rate (i
n
= i
r
+ inflation rate). This is
because the inflation rate is slow to adjust.
Changes in the real interest rate spending plans:
If i
r
I & C
If i
r
I & C
These changes in spending production & prices
3
3 short-run situations
MS
Mdo
Md1
Md2
Qty of money
Md depends on the
price level.
i
n

4
Money market equilibrium in long-
run
M
S
Mdo
Qty of money
Long-run equilibrium
ir (real interest rate)
+ the inflation rate
determines long-run
equilibrium i
n

(nominal interest
rate)
i
n

Inflation rate
Long-run equilibrium ir
Long-run
equilibrium i
n
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The Quantity Theory of Money
When real GDP equals potential GDP, an increase in the qty of money
brings an equal percentage increase in the price level is called the qty
theory of money.
The velocity of circulation is the number of times in a year that the average
dollar of money gets used to buy final goods & services.
The value of final goods & services = nominal GDP = real GDP (Y) X price
level (P)
Velocity of circulation (V):
V = P.Y
___
M M = qty of money
e.g. if the GDP deflator = 125 125/100 = 1.25
real GDP (Y) = 8 M = 2
V = 1.5 X 8
_____ = 6
2
6
Contd.
The equation of exchange:
The qty of money (M) X V = P X Y
M.V = P.Y
V and Y are constant ( in long-run)
If M P must increase by the same percentage that M increased.
Real GDP, Y = $8 billion
Qty of money, M = $2 billion
Velocity of circulation, V = 5
P = M.V 2 X 5
___ = _____ = 1.25
Y 8
M from $2 billion to $2.4 billion
The percentage increase in M = 2.4 2
_____ X 100 = 20%
2
P from 1.25 to 1.5 the percentage increase in P = 1.5 1.25 X 100 = 20%
_______
1.25
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Inflation and the Qty Theory of Money
What determines the inflation rate?
M.V = P.Y
logM + logV = logP + logY
dlogM + dlogV = dlogP + dlogY
dM + dV = dP + dY
__ __ ___ ___
M V P Y
Money growth + velocity growth = inflation + real GDP growth
e.g. money growth = 4%/ year
Velocity growth = 1%/ year
Real GDP growth = 3%/ year
4% + 1% = inflation + 3%
Inflation = 2%/ year
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Inflation
Definition
The continual increase in average prices.
The value of money/ purchasing power of
money refers to the amount of goods and
services one ringgit can buy.
Inflation means the value of money is falling
because prices keep rising.
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Causes of inflation
Cost-push inflation occurs when a firm passes on
an increase in production costs to the consumer.
The inflationary effect of increased costs can be the
result of
(i) Increased wages, leading to
- A wage-price spiral, which occurs when price
increases spark off a series of wage demands which
lead to further price increases and so on.
- A wage-wage spiral, which occurs when one group of
workers receive a wage increase which sparks off a
series of wage demands from other workers.
10
Contd.
(ii) Increased import prices which can be the
result of
- A rise in world prices for imported raw
materials.
- A depreciation of ringgit/ domestic currency.
(iii) Increased indirect taxation
- Demand-pull inflation occurs when there is
too much money chasing too few goods
because the demand for current output
exceeds supply.
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Demand-pull inflation
AD
AD
AS
inflation
Price
level
output
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Effects of inflation
Advantages
The government finds that people earn more
and so pay more income tax.
Firms are able to increase prices and profits
before they pay out higher wages.
Debtors/ borrowers gain because they use
money now, when its purchasing power is
greater.

13
Contd.
Disadvantages
People on fixed income.
Creditors/ savers lose because the loan will have
reduced purchasing power when it is repaid.
Domestic goods become more expensive than
foreign-made products so the B/P suffers.
Industrial disputes may occur if workers are unable to
secure wage increases to restore their standard of
living.
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Remedies of inflation

Cost-push remedies
Introduce price and income policies to freeze
price and wage increases.
Encourage an appreciation of ringgit.
Reduce indirect taxation

15
Contd.

Demand-pull remedies
Reduce government spending.
Increase income tax to reduce consumer
spending.
Reduce peoples ability to borrow money by
increasing interest rates and tightening credit
regulations.
Control the supply of money.
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Unemployment and inflation
Society faces a short-run tradeoff between
unemployment and inflation.
If policymakers expand AD, they can lower
unemployment, but only at the cost of higher
inflation.
If they contract AD, they can lower inflation,
but at the cost of temporarily higher
unemployment.
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The Phillips Curve
PC
Unemployment rate (%) 4 7
2
6
Inflation
rate
(%/year)
The Phillips curve
illustrates the short-run
relationship between
inflation and
unemployment.
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AD, AS, and the Phillips curve
The PC shows the short-run combinations of
unemployment and inflation that arise as
shifts in the AD curve move the economy
along the short-run AS curve.
The greater the AD for goods and services,
the greater is the economys output, and the
higher is the overall price level.
A higher level of output results in a lower
level of unemployment.
(see next slide)
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Contd.
Low AD
High AD
AS
102
106
Y
7500 8000
U=7%
U=4%
Price
level
PC
2
6
Inflation
rate
4 7 U(%)
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The Long-run Phillips Curve
In the 1960s, Friedman and Phelps
concluded that inflation and unemployment
are unrelated in the long-run.
As a result, the long-run PC is vertical at the
natural rate of unemployment.
Monetary policy could be effective in the
short-run but not in the long-run.
(see next slide)
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Contd.
U*
Natural rate of unemployment
U(%)
LRPC
Inflation
rate
High
inflation
Low
inflation
When the CB Ms, the rate
of inflation increases but U
remains at its natural rate in
the long-run.
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The Relationship between the PC and
the AD-AS model

Ms P inflation rate
But leaves output and unemployment at their
natural rates.

(see next slides)

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Contd.
AD1
AD2
P1
P2
Yp
Potential output/ natural
rate of output
Price
level
Inflation
rate
LRPC
LRAS
U*
Natural rate of unemployment