MacroEconomics

Ummad Mazhar, PhD

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 Session 11: Roadmap
• Why inflation results from rapid growth in the money supply?
• What is the meaning of the classical dichotomy and monetary
neutrality?
• Why some countries print so much money that they experience
hyperinflation?
• How the nominal interest rate responds to the inflation rate?
• What are the various costs that inflation imposes on society?

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 Inflation and price level
• Inflation is the rate of change of prices

• Two things should be noted about inflation

• (1) Inflation is the persistent increase in prices over time. It is
not a one time increase in prices.
• (2) Inflation is the average increase in price level. It is not the
increase in all prices

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 Persistent increase in price level
• If a country experiences:
• Percentage change in price
level in year 1 = 5 percent
• Percentage change in price
level in year 2 = -2 percent
• Percentage change in price
level in year 3 = 1 percent
• This is not inflation, average
increase per year of 1.3 percent
• This is normal rate of inflation
• If a country experiences:
• Percentage change in price
level in year 1 = 8 percent
• Percentage change in price
level in year 2 = 7 percent
• Percentage change in price
level in year 3 = 9 percent
• This is inflation, average
increase per year of 8 percent
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 Average increase in price level
• Elaboration of the point 2: Increase in average price level means
some prices increase and some may not increase. There are
winners and losers

• If prices of all goods and services increase together then nobody

will hurt

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 Price level and the value of money
• When the price level rises, people have to pay more for
the goods and services that they purchase.
• A rise in the price level also means that the value of
money is now lower because each dollar now buys a
smaller quantity of goods and services.
• If P is the price level, then the quantity of goods and
services that can be purchased with $1 is equal to 1/P.
• Inverse relation between price level and value of money

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 MS, MD, and monetary equilibrium
• The value of money is determined by the supply and demand for
money.
• For the most part, the supply of money is determined by the
central bank
• This implies that the quantity of money supplied is fixed (until the
central bank decides to change it).
• Thus, the supply of money will be vertical (perfectly inelastic)

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 Money demand
• The demand for money reflects how much wealth people want to
hold in liquid form
• One variable that is very important in determining the demand for
money is the price level.
• The higher prices are, the more money that is needed to perform
transactions
• Thus, a higher price level (and a lower value of money) leads to a
higher quantity of money demanded

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• In the long run, the overall price level adjusts to the level at which
the demand for money equals the supply of money
• If the price level is above the equilibrium level, people will want to
hold more money than is available and prices will have to decline.
• If the price level is below equilibrium, people will want to hold
less money than that available and the price level will rise.

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Monetary equilibrium

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• The left-hand vertical axis is the value of money, measured by
1/P.
• The right-hand vertical axis is the price level (P ). Note that it is
inverted—a high value of money means a low price level and
vice versa.
• At the equilibrium, the quantity of money demanded is equal to
the quantity of money supplied.

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 The effect of monetary injection
• Assume that the economy is currently in equilibrium and the Fed
suddenly increases the supply of money.
• The supply of money shifts to the right.
• The equilibrium value of money falls and the price level rises.
• When an increase in the money supply makes dollars more plentiful,
the result is an increase in the price level that makes each dollar less
valuable.
• Quantity theory of money: a theory asserting that the quantity of
money available determines the price level and that the growth rate
in the quantity of money available determines the inflation rate.
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Effect of monetary injection

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Money supply changes and adjustment process
• The immediate effect of an increase in the money supply is to
create an excess supply of money.
• People try to get rid of this excess supply in a variety of ways.
• They may buy goods and services with the excess funds.
• They may use these excess funds to make loans to others by
buying bonds or depositing the money in a bank account. These
loans will then be used to buy goods and services.
• In either case, the increase in the money supply leads to an
increase in the demand for goods and services.

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 Classical dichotomy and monetary neutrality
• Two types of variables in classical macroeconomics:
• Nominal variables: variables measured in monetary units.
• Real variables: variables measured in physical units

• Classical dichotomy: the theoretical separation of nominal and

real variables.
• Prices in the economy are nominal (because they are quoted in
units of money), but relative prices are real (because they are
not measured in money terms).

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• Classical analysis suggested that different forces
influence real and nominal variables.
• Changes in the money supply affect nominal
variables but not real variables.
• Monetary neutrality: the proposition that changes in
the money supply do not affect real variables.

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 Velocity and quantity equation
• Velocity of money: the rate at which money changes hands.
• To calculate velocity, we divide nominal GDP by the
quantity of money

• or quantity equation
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• The quantity equation shows that an increase in the
quantity of money must be reflected in one of the other
three variables.

• Specifically, the price level must rise, output must rise, or

velocity must fall.
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• Recall inflation is the % change in average price level
• We can translate quantity equation into inflation
equation by writing it in percentage terms
• % change in M + % change in V = % change in P + %
change in Real GDP
•
• Assumption: velocity is constant i.e., = 0
• So =

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 Classical theory of inflation
1) The velocity of money is relatively stable over time.
2) When the central bank changes the quantity of money (M ), it will
proportionately change the nominal value of output (P × Y ).
3) The economy’s output of goods and services (Y ) is determined
primarily by available resources and technology. Because money is
neutral, changes in the money supply do not affect output.
4) This must mean that P increases proportionately with the change
in M.
5) Thus, when the central bank increases the money supply rapidly,
the result is a high level of inflation.
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MS, velocity, and nominal GDP in Pakistan

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See you next time

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