Macroeconomics: Lecture 5 (part 2)

The Classical Theory of Inflation

Inflation is an increase in the overall level of prices.
Deflation is a decrease in the overall level of prices.
Hyperinflation is an extraordinarily high rate of inflation.

P: the inflation is different from the price level, because the inflation is the percentage change in
the price level and the price level is a state of the general level of prices. While price level is
measured by CPI or GDP deflator.

The inflation is…

Inflation: Historical Aspects

o Over the past 70 years, prices have risen on average about 4 percent per year.
o Deflation, i. e. decreasing average prices, occurred in the nineteenth century and in
the Great Depression.
o Hyperinflation refers to high rates of inflation such as Germany experienced in the
1923.
o In the 1970s prices were rising by 7 percent per year.
o During the 1990s, prices were rising at an average rate of 2 percent per year.

Value of money
o The quantity theory of money is used to explain the long-run determinants of the
price level and the inflation rate.
o The quantity theory of money was founded by John Locke and David Hume,
developed by Alfred Marshall, Irving Fisher and was advocated more recently by
Milton Friedman.
o This theory can explain moderate inflation as well as hyperinflation.
P: Is a theory, which explains how price level has been determine in the long run and then it was
determine by the amount of money in circulation

Quantity theory of money says that when the quantity of money in circulation increases, the prices
increase proportionately.

Important insight:
o If all prices are rising at the same time, it’s not the goods that become more
valuable…
o … rather, it’s the money that becomes less valuable.
o So, inflation is more about the value of money than about the value of goods
because…
Macroeconomics: Lecture 5 (part 2)
P: it’s more about purchasing power of money, which decreases. If you see prices of goods and
services that you keep buying increases, money become less valuable.

The price level can be viewed in two ways:

1) We have viewed the price level as a number representing the level of all prices in
an economy
2) We also can view the price level as a number representing the value of money
A rise of price level means a lower value of money (each dollar now buys smaller quantity of
goods).

P: the price level is a number which represents the average level of prices in the economy.

P - price level
1/P - reciprocal value of the price level.
o P is a number which represents the level of prices which are measured in terms of
money.
o 1/P is a number which represents the value of money which is measured in terms of
goods and services.
P: the higher price level the less you can buy for one unit of money in terms of good and services.

A Single Price Example

o When the price of a hamburger (p) is $2, then the value of a dollar (1/p) is half of a
hamburger.
o When the price of a hamburger (p) is $4, then the value of a dollar (1/p) is a quarter of a
hamburger.

P: 1 USD lost 50% of its purchasing power, because with 1 USD you can buy half a hamburger
and now you can buy only ¼ of the hamburger. The loos of purchasing power of 1 average dollar
and in the real economy we have 1000 and 1000 of goods and in that case we can not measure
actual prices but we need to work with the price index.

o The actual economy produces thousands of goods and services, so, we use a price index
rather than individual prices of particular goods.
o When the overall price level rises, the value of money falls.

Price index example

When, in 2015, the overall level of prices measured by means of CPI is 165 with respect to the
base year 2000,

Then the value of a 2015-dollar is

1/1.65 of a 2000-dollar:
1 USD2015 = 1/1.65 USD2000
1 USD2015 = 0.606 USD2000
or
1.65 USD2015 = 1 USD2000
Macroeconomics: Lecture 5 (part 2)
If 1 USD2015 = 1/1.65 USD2000,
it means that: for 1 dollar in 2015, you can buy such a quantity of goods as you could for 0.606
dollar back in 2000.
In other words: CPI=165 tells me that today’s dollar can only buy a 100/165 of the quantity of
goods that I could buy for the same dollar back in the base year.
The difference of 0.394 dollar is a loss of value of money caused by inflation.

Money Supply
The money supply is a policy variable that is controlled by the central bank.
o Through instruments such as open-market operations, the central bank controls the
quantity of money supplied indirectly.

o When CB sells bonds, the reserves of commercial banks decrease and the money supply
contracts.
o When CB buys bonds, the reserves of commercial banks increase and the money supply
expands.
P: from the accounting view point the reserves are assets of the commercial bank, money is
liabilities of commercial banks.

Money Demand
People want to hold money because:
• it is a medium of exchange (→ transaction demand)
→ The amount of money people want to hold depends:
• positively on the price level people need to carry out their
everyday transactions
• positively on the real output
• it is a unit of account
• it is a store of value (→ speculative demand)
→ The amount of money people want to hold depends:
• positively on the price level
speculations are proportional to
income

• positively on the real output

• negatively on IRnom ↑current IRnom → ↓future
IRnom → ↑future Pbonds

IRnom is the
opportunity cost of holding money
Macroeconomics: Lecture 5 (part 2)
The motives of money demand

P: the first two motives try to explain why people want and why people decide to hold money, one
is that you need money because it reduces the transaction cost in the transactions, so you need
money as a medium of exchange. You receive your income in time t1, but the spendings come to
you in time t2, t3,t4.. If your spendings happened in the same time as your income comes to you
then keeping money would be unnecessary.

Money demand has three determinants:

P: the nominal interest rate is explaining the willingness of people or unwillingness of households
to keep money by means of the liquidity preference theory and the real GDP and price level explain
the willingness of households to keep money by means of speculate demand and transaction
demand.

P: first, people are willing to give up the interest because money is very liquid and because money
is needed as a medium of exchange as a general equivalent and because they want to be prepared
for buying of non-monetary interest bare asset in the future and for these reasons they want to keep
money even if they do not build the interest.
Macroeconomics: Lecture 5 (part 2)
Money Market Equilibrium

P: we assume that in the long run the willingness of holding money does not depend on the nominal
interest rate. This reduces the amount of determinance from three to only two. The quantity of
money demanded can be only depend on the real GDP and price level. Factors of production are
constant, the real GDP does not change, the nominal interest rate may change but does not have
any effect on the willingness of people to hold money. The result is only the price level.

1. If the price level is above the equilibrium level, people will want to hold more money than
the CB has created, so the price level must fall to balance the supply and the demand
2. If the price level is below the equilibrium level, people will want to hold less money than
the CB has created, so the price level must rise to balance the supply and the demand
• At the equilibrium price level, the quantity of money that people want to hold exactly
equals the quantity of money supplied by the CB.