Lecture 16: Money and the Price Level I

L11200 Introduction to Macroeconomics 2009/10

Reading: Barro Ch.102 March 2010

Introduction

• Last time:– Completed Economic Fluctuations topic by

explaining fluctuations in unemployment– Arise due to natural unemployment rate varying

over the business cycle

• Today– Begin new topic on money– Consider money demand and supply

Where are we going

• Want to incorporate money demand in to the model– So far ignored the issue: assumed that household

held a constant amount of money used to fund transactions

• Understand pattern of prices and inflation– History suggests price variation can change

radically– Controlling inflation has been a key policy issue

for modern governments

Money

• People get confused about money– Think outcomes of models will change when we

introduce money– Silly ideas around, such as the idea that banks can

‘create’ money– Disconnect the ‘monetary economy’ from the

model of output, incomes, wages etc– Real story is actually much more simple

Concepts of Money

• Without money, you have barter– People exchange goods for goods– Complicated, messy and inconvenient

• Money is a medium of exchange– Households are willing to accept money in lieu of

goods and services: money stores value– Households can access this value when they want

to by exchanging it for goods / services

Concepts of Money

• Money itself is just paper: ‘fiat money’– Historically, people have used valuable

commodities as money (e.g. gold) because of lack of legal enforcement of fiat money

– Use ‘commodity money’ so if society non longer recognises value of commodity as money, it has some intrinsic value (e.g. as gold)

– Commodity money is a waste of resource– We will only consider fiat money

Money Demand

• There is an opportunity cost to holding money– It could be invested in bonds or capital– But you need it to carry out transactions (buy

goods, new capital, new bonds)– Trade-off: if you hold more money, you have it

available for transactions and don’t need to incur the cost of going to the bank so often

– If you hold less money, you earn more interest at the bank

Money Demand

• What affects this decision– Interest rate: if the interest rate is higher, you

want to hold less money and put more in the bank (where it earns interest)

– Price level: if prices are higher, you need more money to service transactions

– Output: if you have more output (income), you need more money to exchange the higher level of output

Money Demand Function

• So we can establish a general function

• Often express this in real terms. If prices double, money held doubles, so in real terms no change occurs:

• Empirical studies suggest this is accurate

( , )dM P L Y i

/ ( , )M P L Y i

Equilibrium Price Level

• What about supply of money?– Money supply is fixed by the government. – They print a certain amount of money so that

transactions can take place easily– Needs to be divisible (so prices can be easily

divisible)– So price of goods change due to changes in

demand and supply

Ms=Md

• Changing money supply changes the price level in the economy– E.g. government doubles amount of printed

money in economy and distributes it randomly– Everyone has more nominal money, demand for

everything doubles– Prices double, wages doubles, rents double– So in real terms nothing changes– Money is neutral, hence term ‘money neutrality’

Money Neutrality

• This is essentially a simple idea– Money is just paper currency. The price of a good

in isolation doesn’t mean anything, it is only the price of one good relative to another that matters

– So if everyone is given more money (but continues to buy the same goods) all prices double

– Relative prices are unchanged.– Nothing has changed

Money Illusion

• This would not be the case if– People got confused between the nominal value

(£) of things and the real value– E.g. people only worry about their wage in £– When prices double, they don’t realise that their

wages are worth less, so don’t negotiate– This is called money illusion

Summary

• Created model of money demand and supply– Trade-off between holding money and buying

bonds instead– When prices rise, money holdings rise 1:1, so no

effect on real money balance– When money supply rises, prices rise 1:1, all real

variable unchanged, no effect on activity

• Next time: Examine changes in money demand