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Chapter 15 Inflation: A Monetary Phenomenon

Chapter 15 Inflation: A Monetary Phenomenon. Money and the Economy Pg. 374-388. Money. Money – anything generally accepted as final payment of goods, services, and debt. Money - 3 Functions – 1) A unit of account 2) A medium of exchange 3) Store of value. The Money Supply.

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Chapter 15 Inflation: A Monetary Phenomenon

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  1. Chapter 15 Inflation: A Monetary Phenomenon Money and the Economy Pg. 374-388

  2. Money • Money – anything generally accepted as final payment of goods, services, and debt. • Money - 3 Functions – • 1) A unit of account • 2) A medium of exchange • 3) Store of value

  3. The Money Supply • The narrowly defined money supply (M1) is the sum of all coins and paper money in circulation, plus certain checkable deposits and savings institutions. • The broadly defined money supply (M2) which is (M1) plus all types of checking account balances most forms of savings accounts and shares in money market mutual funds.

  4. The Federal Reserve Central bank independence – meaning that the bank able to make decisions without political interference. • Controls the nations money supply. • Conducts monetary policy. • Supervises the nations money supply.

  5. Causes of Inflation • Inflation is a continuing rise in the price level • Inflation is a long run phenomenon • Inflation is best explained by the “Quantity Theory of Money.” • The Quantity Theory of Money states: The money supply is the principal determinate of Nominal GDP.

  6. Quantity Theory of Money • The Equation Of Exchange: the shows the relationship between the money supply (M), the income velocity of money (V), the GDP deflator (P), and real GDP. • M * V = P * GDP • (M * V) = represents the amount spent on final goods and services. • (P * GDP) = represents the amount received for those goods and services.

  7. Determining the Impact Of An Increase In the Money Supply On The Inflation Rate • We change the Formula into a growth formula • %▲M + %▲V = %▲P + %▲GDP

  8. Quantity Theory of Money 2 Assumptions • 1) Output Growth Rate is constant. • 2) The Velocity of Money is constant • With these 2 assumptions we can now have an equation to show us the impact the money supply has on inflation.

  9. Quantity Theory of Money • By holding (V) constant (or equal to zero) we can now formulate this statement: • %▲M = %▲P + %▲GDP • This states that the growth rate of the money supply equals the inflation rate plus the output growth rate.

  10. Quantity Theory of Money • So if we wanted to know the inflation rate we change the equation to: • %▲P = %▲M - %▲GDP • This states that the inflation rate equals the growth rate of the money supply minus the output growth rate. • Example : If the money supply is growing at 8% and the Output growth rate at 3 % the inflation rate would = 5%

  11. Why are Velocity and Output held constant? • 1) Output Growth Rate : Typically output grows at about 3% • 2) In the long run the velocity of money stays relatively constant.

  12. Inflation and Policy • Monetary Policy – use of interest rates and the money supply to alter aggregate demand • Fiscal Policy – taxation and government spending to alter aggregate demand • Supply Side Policies – Policy aimed at increasing aggregate supply • Income Policy – policies other than monetary and fiscal that aim at influencing or controlling the rate of price wages and other forms of income.

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