12.2
Money, the Price Level, and Inflation
The Money Market in the Long Run
 In the long run, the nominal interest rate equals the equilibrium real interest rate plus the
inflation rate and the real interest rate is independent of the price level.
The important conclusion from this observation is that in the long run the nominal interest rate
cannot change simply to maintain equilibrium in the money market. Something else must
change. And that is the value of money.
 The “price” of money is the value of money.
The value of money is the quantity of goods
and services that a unit of money will buy. It
is the inverse of the price level.

Intuitively “P” tells you how many dollars it
takes to buy a good or service. Therefore
“1/P” tells them what fraction of the good or
service 1 dollar will buy…which is the value
of money!
o For instance, you can point out that if
a burger costs 1 dollar, then the value
of a dollar is 1 burger. Now, if
Wendy’s doubles the price of its
burgers to $2 per burger, then the
value of your dollar bill has fallen by
½--it now takes 2 dollar bills to buy 1burger so each dollar bill is worth only ½
burger.
A Change in the Quantity of Money in the Short Run and the Long Run
In the short run, when there is an increase in the money supply, nominal interest rates
decrease. Since people do not change their inflation expectations, real interest rates decrease.
This causes people to borrow more and invest more.
Aggregate demand increases.
 An increase in the quantity of money lowers the nominal interest rate.
In the long run:
 In the long run, real GDP = potential GDP
 Prices will begin to begin to rise, so the value of money decreases. Other things
remaining the same, a given percentage increase in the quantity of money brings an equal
percentage increase in the price level.
 An increase in the quantity of money lowers the value of money (1/P)
The Quantity Theory of Money
 The quantity theory of money is the proposition that when real GDP equals potential
GDP, an increase in the quantity of money brings an equal percentage increase in the
price level.
 The velocity of circulation is the number of times in a year that the average m dollar of
money gets used to buy final goods and services.
 Nominal GDP equals real GDP, Y, multiplied by the price level, P, or GDP=P  Y. So
the velocity of circulation, V, is given by V = (P  Y) ÷ M.
 The equation of exchange states that the quantity of money, M, multiplied by the
velocity of circulation, V, equals the price level multiplied by real GDP:
M  V = P  Y.
o The equation of exchange is a definition and so is always true. It becomes the
quantity theory of money by adding two facts:
 Real GDP equals potential GDP at full employment, and potential GDP is
determined by only real factors and not the quantity of money.
 The velocity of circulation does not change when the quantity of money
changes.
o Rearrange the equation of exchange as P = (M  V) ÷ Y = M  (V ÷ Y). According
to the quantity theory, velocity and potential GDP are not influenced by the
quantity of money. So an x percent change in M results in the same x percent
change in P.
Inflation and the Quantity Theory of Money
 In rates of growth, the equilibrium of exchange is
(Money growth) + (Velocity growth) = (Inflation rate) + (Real GDP growth).
 The previous equation can be rearranged as (inflation rate) = (Money growth) + (Velocity
growth)  (Real GDP growth). This formula concludes that in the long run, the
percentage increase in the price level, which is the inflation rate, equals the percentage
increase in the quantity of money plus the percentage increase in velocity minus the
percentage increase in real GDP. If the growth rates of velocity and real GDP do not
change when the money growth rate changes, then changes in the money growth rate lead
to equal changes in the inflation rate.
12.3 The Cost of Inflation
Inflation has adverse effects that decrease potential GDP and slow economic growth:
 When money growth increases, inflation increases slowly so there is a temporary
increase in the real GDP growth rate.
o Faster inflation decreases potential GDP and slows real GDP growth because of
the cost of inflation. If there is low inflation, then these costs are relatively small
and are dominated by the main effect of money growth on the inflation rate.
 Tax Costs: Because inflation increases the nominal interest rate and because it is the
income from the nominal interest rate that is taxed, higher inflation reduces the after-tax
real interest rate, thereby decreasing people’s incentive to save and invest. Capital
accumulation slows so real GDP growth slows.
 Note that:
after tax interest rate = real interest rate – (nominal interest rate* income tax rate)
o Suppose that the real interest rate =10% and the income tax rate= 20%.
 If there is no inflation:
 Marginal interest rates= real interest rates
 after tax interest rate = 10- (10*0.2)= 8 percent
 If inflation equals 2 percent
 Marginal interest rates= real interest rate+ inflation = 12 percent
 after tax interest rate = 10-(12*0.2)=7.6 percent



Confusion Costs: Inflation makes it more difficult to use prices to compare marginal
benefits to marginal costs.
Increased Uncertainty: High inflation is correlated with increased uncertainty about the
inflation rate. This increased uncertainty leads people to spend more time predicting
inflation and less time at productive activities, which slows the economic growth rate.
Shoe-Leather Costs: High inflation generates transaction costs as individuals try to avoid
losses from the falling value of money.
o In countries with high inflation, wage payments are made more frequently,
sometimes multiple times a day in the middle of a hyperinflation. Workers try to
spend their wages as quickly as possible before the money loses too much value.
o This transaction cost is referred to as a “shoe-leather cost” because of the idea of
individuals wearing out their shoes as they rush around to convert money to goods
and services or other assets before it loses its value.

A hyperinflation is inflation at a rate that exceeds 50 percent a month. Hyperinflations
are the result of extremely rapid money growth.

Example: Germany in the 1920’s:
o During the month of maximum inflation in Germany the average daily inflation
rate was 20.5 percent.

The quantity of money increased by 43 billion percent in 1923.
o What is surprising is that even though the money supply was increasing rapidly,
price levels climbed even faster. This was because of the tremendous
opportunity cost of holding money increased the velocity of money.

Change in M + Change in V= Change in P+ Change in Y



Since Y is constant, the only way for P to increase by more than M
is if V is also increasing.
Why might the velocity of money have been faster during a period of
hyper inflation?
Example: Zimbabwe hyperinflation
o http://www.youtube.com/watch?v=mM3_z2RB3YU
o http://www.youtube.com/watch?v=VNXc0HEDDrE
o People started to only accepting foreign currency in Zimbamwe because the
domestic currency no longer served any of the three functions of money.


Was not a medium of exchange

Was not a unit of account

Did not store value:
A deflation is also negative because of the fear that it could promote financial instability
and precipitate a severe economic contraction
o Deflation benefits people who hold liquid assets and savings
o Deflation hurts borrowers because the real value of their loan increase
13.1 Aggregate Supply
The purpose of the AS-AD model is to explain how the
price level and real GDP are determined. Real GDP
depends on labor, capital, technology, land, and
entrepreneurial talent.
 In the short run, only the quantity of labor can
vary, so fluctuations in employment lead to
changes in real GDP.
 In the long run, prices will be determined by real
factors only (the price level will not affect the
level of real GDP)
o The Long Run AS= potential GDP
o When the quantity of labor demanded equals the quantity of labor supplied, there
is full employment in the labor market and real GDP equals potential GDP.
Aggregate Supply Basics
 The (short-run) aggregate supply curve is the relationship between the quantity of real
GDP supplied and the price level when all other influences on production plans (the
money wage rate, the prices of other resources, and potential GDP) remain constant.
o It assumes that product prices and resources prices do not move in lock step with
one another. That is to say that wages, materials prices, energy prices and the like
move with a lag behind product prices.
 As illustrated in the figure, the AS curve is upward sloping.
o This slope reflects that a higher price level combined with a fixed money
wage rate, lowers the real wage rate, thereby increasing the quantity of
labor employed and hence increasing real GDP.
 A secondary reason for the positive slope is that firms that are slow to
raise prices in response to an increase in price level will find that sales
increase and will therefore increase production.
o The reason that prices do not adjust is that:
 Contracts are sticky: If people sign nominal contracts for inputs and
wages in advanced that last for a long period of time. If there is a
change in the price level people will not be able to renegotiate the
price/ wage rate until the contract is over.
 Firms are slow to adjust wages: Historically firms only change
wages once a year for several years. This causes wages to adjust more
slowly than prices, which change relatively frequently.
 Menu costs make some prices sticky: Firms may advertise their
prices based on their expectations. If the actual price level does not
meet their expectations, then they may incur a cost to change their
prices.
 The potential GDP line (LRAS curve) is vertical because moving along it both the
price level and money wage rate and money prices of other resources change by the
same percentage.
o Moving along the potential GDP line the following are true:


Real wage rate stays at full employment level

Money wage rate changes by the same percentage as the change in
prices

Money prices of non-labor resources change by the same percentage as
the change in prices
When the price level changes, three reactions create the positive relationship between the
price level and quantity of real GDP supplied in the SR:
 Changes in output rate: When the price level rises and the money wage rate doesn’t
change, the quantity of labor demanded increases and production increases.


Temporary shutdowns and restarts: The price level relative to costs is an influence
on temporary shutdown decisions. If the price level rises relative to costs, fewer firms
will decide to shut down, so more firms operate and the quantity of real GDP supplied
increases.
Business failure and startup: Real GDP changes when the number of firms in
business changes. If the price level rises relative to costs, profits increase, the number
of firms in business increases, and the quantity of real GDP supplied increases.
Changes in Aggregate Supply
 When the price level changes and the money wage rate and other resource prices remain
constant, real GDP departs from potential GDP and there is a movement along the AS
curve. The AS curve, however, does not shift.
 When potential GDP increases, aggregate supply increases and AS curve shifts rightward.
The potential GDP line also shifts rightward.
 Short-run aggregate supply changes and the AS curve shifts when there is a change in the
money wage rate or other resource prices. A rise in the money wage rate or other resource
prices decreases short-run aggregate supply and shifts the AS curve leftward. In this case,
the potential GDP (LRAS curve) line does not shift.
Factors that increase Potential GDP (LRAS)
 Real GDP increases
 The number of workers in the economy increase
 Capital improves
 Postive technology shock makes workers or technology more productive
(opposite effects will shift the LRAS curve in)
Factors that increase (Short Run) Aggregate Supply
 Factors that increase potential GDP
o Real GDP increases
o The number of workers in the economy increase
o Capital improves
o Postive technology shock makes workers or technology more productive
(opposite effects will shift the LRAS curve in)
 The expected future price level decreases (because workers and firms increase wages and
prices which increase the cost of producing)
 The expected price of an important natural resource decreases (costs of producing output
rise)
 Workers and firms adjust to having over-estimated the price level (because workers and
firms increase wages and prices which increase the cost of producing)
(opposite effects will shift the LRAS curve in)
13.2 Aggregate Demand
The quantity of real GDP demanded is the sum of
consumption expenditure (C ), investment
(I ), government expenditures (G ), and net exports (X
 M ), or Y = C + I + G + (X  M ).
Aggregate Demand Basics
 The relationship between the quantity of real
GDP demanded and the price level is called
aggregate demand. Other things remaining
the same, the higher the price level, the
smaller is the quantity of real GDP demanded.
 As the figure shows, the AD curve is
downward sloping. Moving along the
aggregate demand curve the only thing that
changes is the price level.
Why the AD Curve Slopes Downward
 The negative relationship between the price level and the quantity of real GDP
demanded, that is, the negative slope of the AD curve, reflects three factors:
 Buying power of money: When the price level rises, the buying of money decreases
and so people decrease consumption expenditure.
 Real interest rate: When the price level rises, the demand for money increases,
which raises the nominal interest rate. Because the inflation rate does not immediately
change, the real interest rate also rises so that people decrease their consumption
expenditure and firms decrease their investment.
 Real price of exports and imports: When the price level rises, domestic goods
become more expensive relative to foreign goods so people decrease the quantity of
domestic goods demanded.
Changes in Aggregate Demand

Any factor that influences expenditure plans other than the price level changes
aggregate demand and shifts the aggregate demand curve (Changes in the price level results
only in movements along the curve). Factors that change aggregate demand are:
 Expectations: Expectations of higher future income, expectations of higher future
inflation, and expectations of higher future profits increase aggregate demand and
shift the AD curve rightward.
 Fiscal policy and monetary policy: The government influences the economy by
setting and changing taxes, making transfer payments, and purchasing goods and
services, which is called fiscal policy. Tax cuts, increased transfer payments, or
increased government purchases increase aggregate demand. Monetary policy
consists of changes in interest rates and in the quantity of money in the economy. An
increase in the quantity of money and lower interest rates increase aggregate demand.
 The world economy: Exchange rates and foreign income affect net exports (X  M )
and, therefore, aggregate demand. A decrease in the exchange rate or an increase in
foreign income increases aggregate demand.
Factors that increase Aggregate Demand
 Interest rates decrease (because lower interest rates decrease the cost of borrowing for
firms and households, increaseing consumption and investment.)
 Government purchases increase (because government purchases are a component of
aggregate demand)
 Personal income taxes or business taxes decrease (consumption spending increases when
personal taxes decrease and investment increase when business taxes fall)
 Households’ expectations of their future income increases (consumption spending
increases as people save less)
 Firms’ expectations of the future profitability of investment spending increase
(investment spending increases)
 "Factors that increase Aggregate Demand" there is a typo in the
sizth bullet. It should read that Exports will increase faster
than IMPORTS, which will increase net exports.


The exchange rate (value of the dollar) relative to foreign currencies decreases (imports
fall and exports rise. Therefore net exports increase.
The money supply increases (An increase in the money supply will decrease the interest
rate)
Aggregate Demand Multiplier
 An initial change in expenditure is magnified by the aggregate demand multiplier so
that aggregate demand changes by a multiple of the initial change.
 When any influence on aggregate demand changes expenditure plans, the change in
expenditure changes income and induces a change in consumption expenditure.
o It is for this reason that changes in investment, particularly residential
construction are the cause of most recessions.
13.3
Understanding the Business Cycle
Macroeconomic Equilibrium
 Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals
the quantity of real GDP supplied.
 If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile
up so that firms will cut production and prices.
 If the quantity of real demanded exceeds the quantity supplied, inventories are
depleted so that firms will increase production and prices.
 Macroeconomic equilibrium is determined where the AD and AS curves intersect.
 A full employment equilibrium occurs when equilibrium real GDP equals potential
GDP. An above full-employment equilibrium occurs when real GDP exceeds potential
GDP. A below full-employment equilibrium occurs when real GDP is less than
potential GDP.
Aggregate Demand Fluctuations
 Fluctuations in aggregate demand are one of the sources of the business cycle. Ignoring
changes in potential GDP, when aggregate demand increases, the equilibrium moves
rightward along the AS curve so that real GDP increases and the economy is in an
expansion. When aggregate demand decreases, the equilibrium moves leftward along the
AS curve so that real GDP decreases and the economy is in a recession.
Adjustment Toward Full Employment
The amount by which real GDP exceeds
potential GDP in an above full
employment equilibrium is called an
inflationary gap. An inflationary gap
occurs when the AS curve and the AD
curve intersect to the right of the potential
GDP line, as illustrated in the figure to
the right. In the figure, potential GDP is
$13 trillion but the actual real GDP is $14
trillion. (The inflationary gap =$1
trillion)With this above full-employment
equilibrium, real wages have fallen and
workers eventually demand higher wages.
The tight labor market allows the money
wage rate to increase. Aggregate supply
decreases and the AS curve shifts leftward.
Eventually real GDP decreases enough so
that it equals potential GDP. As this adjustment takes place, the price level rises so that
inflation occurs.

The amount by which potential GDP
exceeds real GDP in a below full
employment equilibrium is called a
recessionary gap. A recessionary gap
occurs when the AS curve and the AD
curve intersect to the left of the potential
GDP line, as illustrated in the figure to
the left. In the figure, potential GDP is
$13 trillion but the actual real GDP is
$12 trillion. (The recessionary gap=$1
trillion) With this below fullemployment equilibrium, real wages
have risen and there is a surplus of labor.
The surplus decreases the money wage
rate. Aggregate supply increases and the AS curve shifts rightward. Eventually real GDP
increases enough so that it equals potential GDP. As this adjustment takes place, the price
level falls so that deflation occurs

The trick to understanding adjustment towards full equilibrium is to remember that
wages and other input prices remain constant along an AS curve. However, if GDP does
not equal potential GDP, we will not stay there forever. Over time, input prices change in
response to the higher level of prices, and the changes in input cost and wages will shift
the AS curve.
Fluctuations in Aggregate Supply
 Some business cycle fluctuations are driven by shifts in short-run aggregate supply. An
increase in energy prices decreases the short-run aggregate supply and shifts the AS curve
leftward. The price level increases and real GDP decreases. The combination of recession
and higher inflation is called stagflation and occurred in the United States in the 1970s as
a result of the oil price shocks.
Deflation and Great Depression
 In the Great Depression from 1929 to 1933, the price level fell by 22 percent and real
GDP fell by 31 percent. In the 2008-2009 recession, the price level rose at a slow pace
and real GDP fell by less than 4 percent. The 2008-2009 recession was much milder than
the Great Depression for various reasons:
 During the Great Depression, bank failures, a 25 percent contraction in the quantity of
money, and inaction by the Fed resulted in a collapse of aggregate demand. Money
wage rates and the price level were slow to adjust, resulting huge decreases in real
GDP and employment.
 During the 2008 financial crisis, the Fed bailed out troubled financial institutions and
doubled the monetary basis, which kept the quantity of money growing. Combined
with increased government expenditure, the growing quantity of money limited the
fall in aggregate demand, thus resulting in smaller decreases in employment and real
GDP.