THE PRICE LEVEL AND INFLATION

The Price Level

 A rise in the overall price level is equivalent to a fall in
the value of money.
 To understand the determination of the price level we
need to understand the interaction of money supply
and money demand.
 Result - the price level is determined by the quantity
of money in the long run.
 In the long run real variables are not affected by
changes in the quantity of money - the classical
dichotomy - monetary neutrality.
 In the short run there may be non-neutrality.
 Money Supply and Money Demand
 The money supply is controlled by the central bank.
 Money demand is the average amount of money people want to hold
over a given period of time.
 Money demand depends on interest rates, the level of expenditure
and the average level of prices in the economy.
 People hold money because it is the medium of exchange
 The nominal value of expenditure is the main determinant of
money demand in the long run.
 An increase in the general price level increases nominal
expenditure (for given real expenditure) and therefore increases
money demand.
 In the long run, the overall level of prices adjusts to the level where
the demand for money equals the supply.
Money
holdings

Average
money
holdings

Time
 An Increase in Nominal Expenditure (P x Y)

Money
holdings

Average
money
holdings
increase
Time
 The Effects of a Monetary Expansion

Value of Price
Money MS1 MS2 Level
(High) 1 1 (Low)

1. An increase
3/4 in the money 1.33
2. ...decreases supply...
the value of
money ... A 3. and
1/2 2 increases
the price
level.
B
1/4 4

(Low) (High)
0 M1 M2 Quantity of
Money
The Transmission Mechanism
 In the short run when the money supply increases people find
that their holdings of money have increased relative to their
nominal expenditure.
 People are now holding more money than they want.
 The only way for an individual to reduce money holdings is to
increase expenditure.
 But in the long run the real supply of goods is determined by the
quantity of inputs.
 And expenditure does not reduce the total nominal quantity of
money.
 The increase in the demand for goods must cause the overall
price level to rise.
 The price level rises until nominal expenditure has risen to the
point where money demand equals supply.
Velocity and the Quantity Equation
 The velocity of money is the average number of times
a pound is used in a given period.

V = (P x Y)/M
Where: V = velocity, P = the price level,
Y = the quantity of output, M = the quantity of money

 The velocity of money is relatively stable over long

periods of time - this is an alternative way of saying
that the main determinant of money demand is
nominal expenditure.
The Quantity Theory of Money
 Rewriting gives the quantity equation.

MxV=PxY

 V is stable and Y is determined by the quantity of

inputs and the production function so changes in M
cause proportional changes in P.
Inflation
 If the central bank causes the money supply to
increase continuously then the price level will rise at
the same rate (on average) - inflation.
 Why would a central bank do this?
 Political incentive - monetary expansion may help
reduce unemployment in the short run.
 To finance expenditure without raising taxes -
inflation is common in countries with inefficient tax
systems.
 The Fisher Effect
 Monetary neutrality tells us that the real interest rate
is unaffected by monetary changes in the long run -
the real supply and demand for loanable funds is
unaffected.
 When the rate of inflation rises, the nominal interest
rate rises by the same amount.

Nominal interest rate =

Real interest rate + Inflation rate
Price Level and Inflation Targeting
 Many central banks have given up trying to control
the money supply - so it’s not accurate to say that
“the money supply determines the price level”.
 In practice policy is framed in terms of a price level or
inflation target.
 The central bank varies the nominal interest rate in
the short term in order to ensure that the inflation
target is met.
 The level of nominal expenditure determines the
demand for money - the central bank allows the
supply of money to vary to accommodate the demand.
 In effect the inflation target determines the money
supply.
Summary
 The overall level of prices in an economy adjusts to
balance money supply with money demand.
 An increase in the money supply causes an equal
proportional increase in the price level.
 Persistent growth in the money supply leads to
inflation.
 Changes in the money supply influence nominal
variables but not real variables.
Summary of the Long Run Model
 Output is determined by the quantity of inputs and the
production function.
 The market for loanable funds ensures that income
which is not consumed is used to increase the capital
stock - real interest rates are determined.
 If the real wage was flexible the labour market would
ensure that all labour offered would be employed
(except for search unemployment) - market
imperfections lead to unemployment - the real wage.
 The nominal side of the economy is independent from
the real side - the overall price level and the money
supply are determined by the monetary strategy of the
central bank.
 Only missing element is the open economy side.
The Short Run
 Data for all macro variables show short-run
fluctuations.
 The economy is constantly hit by shocks.
 The process of movement between different long-run
equilibria is important for understanding short-run
fluctuations.
 The long run analysis has shown a heavy emphasis
on the role of markets and prices.
 The market is one of the basic building blocks of
economics - modern approach to macro emphasises
“microeconomic foundations.”
 Market failure is an important element of macro -
especially in the short run - creates an important role
for policy.