confusing demand-induced and supply induced one shot inflation. An increase in the money supply will lead to a rise in Real GDP in the short run, but then adjustments to labor market. When the money supply increases, the AD curve shifts rightward and, in the short run, Real GDP increases. Monetarists believe that: a. velocity changes in a predictable way. This of course is a caricature. In the simple quantity theory of money, changes in the money supply affect the price level but not Real GDP. a. velocity changes in a predictable way. The price level falls further to P3 and the Real GDP is back at QN position. The interest rate will decline (Exhibit 7b). From the Equation of Exchange to the Simple Quantity Theory of Money The simple quantity theory of money is derived from the equation of exchange by assuming that velocity and real output are constant in the short run, and therefore predicts that any change in the money supply will bring about a strictly proportional change in the price level as shown in Exhibit 1. And in fact Keynesians take the view that velocity is actually unstable. When the price level rises, the purchasing power of money falls and the demand for loanable funds rises. Monetarists also recognise that the demand for money can shift unpredictably in the short run with changing expectations. Simply speaking, M 1 and the gross national product are not what they used to be arid because velocity equals GNP divided by M 1, changes in the numerator and denominator can make a big difference. Explain why it is difficult to predict exactly what will happen to interest rates when the money supply changes. Neo-Keynesians are less confident and argue that either contention is an exaggeration. Is the rise in the interest rate more likely the result of the income effect or of the expectations effect? One-shot inflation occurs when there is a single increase in the price level without any subsequent increases. In the long run, labor markets surpluses will bid down the wage rate, which will shift the AS curve rightward from AS2 to AS3, causing the price level to fall to its original level and causing Real GDP to rise to its original level. The simple quantity theory of money is derived from the equation of exchange by assuming that velocity and real output are constant in the short run, and therefore predicts that any change in the money supply will bring about a strictly proportional change in the price level as shown in Exhibit 1. Scholars, including monetarists, know that quarter- to-quarter changes in velocity are unpredictable. Faced with these higher prices, the consumer-laborers will demand higher wages from their employers, shifting the SRAS leftward, ceteris paribus, and raising the price level. According to monetarists, changes in velocity can, Suppose the nominal interest rate is 10 percent, the expected inflation rate is 6 percent, and the (actual), inflation rate turns out to be 7 percent. Monetarist: A monetarist is an economist who holds the strong belief that the economy's performance is determined almost entirely by changes in the money supply. Velocity Changes in a Predictable Way—Monetarists do not hold velocity to be constant. In the long run, labor market shortages will increase the wage rate, which will shift the AS curve leftward from AS1 to AS2, causing the price level to rise again from P2 to P3 while Real GDP will return to its original level. The relative strengths and timing of the income, liquidity, price-level, and expectations effects will determine the nominal interest rate. Their position was based on the equation of exchange and the simple quantity theory of money. According to them, it changes in ways that can be understood and predicted. Whether the nominal interest rate is higher, lower, or the same today as it was 30 days ago depends on what? When the money supply increases, reserves in the banking system increase and banks can make more loans. Since the SRAS curve is vertical in the simple quantity theory, an increase in the money supply (which shifts the AD curve rightward) will increase the price level but will have no effect on Real GDP. Traditional monetarists used to consider money-velocity as rather stable and predictable. If AD was low, increasing the money supply would only increase short-run economic activity. The Simple Quantity Theory of Money in an AD-AS Framework, 1. c) Monetarists believe that the velocity of money is highly stable. Theoretically, it is easy to compute the real interest rate. Is the interest rate guaranteed to decline initially? Example 1. The AD Curve in the Simple Quantity Theory of Money—MV stands for total expenditures in this theory. In the next round of wage negotiations, workers demand and receive higher wages, shifting the SRAS curve left, as in panel (b). It follows that the. The controversy centres on whether and how V and Q are affected by changes in the money supply (M). The timing and magnitude of these effects determine the change in the interest rate. Usually, the demand for loanable funds increases by more than the supply of loanable funds, so that when the Real GDP increases, the income effect predicts that interest rates will rise. The timing and magnitude of these effects determine the changes in the interest rate. The SRAS curve is upward sloping 4. In order to cause continued inflation, the Federal Reserve would have to increase the money supply every year, which it is capable of doing. Answer: E As a result, any changes in the money supply that cause the aggregate demand curve to shift rightward or leftward will change only the price level but not Real GDP. b. aggregate supply depends on the money supply and velocity. A.Monetarist Views —There are four positions held by monetarists that we need to understand: 1. Explain your answer. In monetarism, an increase in the money supply or in velocity will lead to an increase in aggregate demand. It is difficult to predict exactly what will happen to interest rates when the money supply changes because a change in the money supply affects the economy in many ways: changing the supply of loanable funds directly, changing Real GDP and therefore changing the demand for and supply of loanable funds, changing the expected inflation rate, and so on. Some economists believe the real interest rate is relatively stable over time, so changes in the nominal interest rate are due to changes in the expected inflation rate; but other economists do not agree with this, at least not to the same degree. In the following graph, the economy is initially in equilibrium where AD1 intersects SRAS1 at point1. A decrease in the money supply or velocity, or an increase in Real GDP, is deflationary. Velocity changes in a predictable way but does not change very much from one period to the next 2. D) all of … Explain your answer. For these reasons, monetarists conclude that monetary policy cannot be used for demand management in the short run. The real interest rate. A change in the money supply affects the economy in many ways: changing the supply of loanable funds directly, changing Real GDP and therefore changing the demand for and supply of loanable funds, changing the expected inflation rate, and so on. Some monetarists believe that the velocity’s unexpected behaviour in recent years has to do with problems of definition or measurement. C) changes in government spending and taxes cause the aggregate demand curve to shift. One-shot inflation can originate on either the supply or the demand side. Can anything offset the increase in the money supply so that Real GDP does not rise? d. Monetarists believe that … The money supply, the loanable funds market and interest rates. Traditional monetarists like Milton Friedman, Karl Brunner or Allan Meltzer never claimed that velocity was constant, but rather that the money demand… Aggregate Demand Depends … In an attempt to offset inflation's effects, interest rates are adjusted for the expected rate of inflation, so that the actual interest rate paid (the nominal interest rate) is equal to the real interest rate plus the expected inflation rate. Can you get rid of infaltion with price controls? 59 out of 61 people found this document helpful. The price-level effect is the change in the interest rate due to a change in the price level. The economy is self regulating (prices and wages are flexible) Monetarists believe: the … B. Monetarists believe that the velocity of money is predictable. Graphically show the short run and long run effects of an increase in the money supply or velocity. In the simple quantity theory of money, the velocity of money and the Real GDP are assumed to be constant. Things will not change. With respect to the interest rate, (a) what is the liquidity effect? In the end, the effect on the interest rate due to a rise in the price level remains. The result is that interest rates would rise with an increase in expected inflation (Exhibit 7e). The economy is in a recessionary gap at point 2. B) a change in the quantity of money causes the aggregate demand curve to shift. On the other hand, a supply shock (such as a crop failure) would shift the SRAS curve to the left, causing an increase in the price level. Continued increases in the money supply will turn one-shot inflation into continued inflation. Jennifer received on their savings account over the year? Think of a robotic Fed, no humans to screw it up. The equation of exchange is an identity that states that, From the Equation of Exchange to the Simple Quantity Theory of Money. Yes. Nominal interest rate = Real interest rate + Expected inflation rate. 2. In the above figure, starting from long-run equilibrium at point 1, where AD1 intersects SRAS1, a fall in velocity will shift the AD curve leftward to AD2. M is a vertical line (see diagram 3 above). To achieve that direct effect, though, the velocity of money must be predictable. In the 1970s velocity increased at a fairly constant rate and it appeared that the quantity theory of money was a good one (see chart). When the money supply increases, the AD curve shifts rightward and the price level rises. A second interpretation is that the money supply multiplied by velocity must equal GDP. Agree. The difference between the price-level effect and the expectations effect. Economists distinguish between a one shot increase and a continued increase. A one-shot supply-side induced inflation causes the SRAS curve to shift leftward from SRAS1 to SRAS2, causing the price level to increase from P1 to P2. Moreover, monetarists contend that velocity does not change in response to changes in supply of money. Monetarists say that velocity, V, is stable, meaning that the factors altering velocity change gradually and predictably. No. For inflation to continue there would have to be crop failures every year without a reallocation of resources to farming to offset the decrease in supply. Suppose the money supply rises. Monetarists believe there is a strong relationship between changes in the money supply and inflation. Explain what happens to the supply of loans when the money supply increases. This is called the price-level effect. The reason is that it is easier to produce continuous increases in aggregate demand that increase the price level than for the economy to undergo continuous supply shocks. Some monetarists believe that the velocity’s unexpected behaviour in recent years has to do with problems of definition or measurement. Keynesian and monetarist theories offer different thoughts on what drives economic growth and how to fight recessions.