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NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)

<< NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates >>
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Macroeconomics ECO 403
VU
LESSON 10
NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
(Continued...)
The Role of Govt.
·
If the Government:
·
increases defense
spending: ΔG > 0
·
big tax cuts: ΔT < 0
·
According to our model, both policies reduce national saving:
S = Y ­ C(Y - T) - G
↑
G => ↓ S
↓ T => ↑ C => ↓ S
The Role of Govt.
r
S2
S1
r2
r1
I (r )
I2
I1
S, I
1. The increase in the deficit reduces saving...
2. ...this causes the real interest rate to rise...
3. ...this reduces the level of investment.
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Macroeconomics ECO 403
VU
An increase in investment demand
r
S
An increase
...raises the
in desired
interest rate.
r2
investment...
r1
But the equilibrium level of
investment cannot increase
I2
because the supply of
I1
loanable
funds is fixed.
S, I
Saving and the interest rate
· Why might saving depend on r?
· How would the results of an increase in investment demand be different?
­  Would r rise as much?
­  Would the equilibrium value of I change?
Rise in investment demand when saving depends on interest rate
Real interest
r
rate,
S (r)
1. An increase
in desired
B
2. . .  . raises
investment
the interest
A
rate
I2
3. .
. and raises
I1
equilibrium investment
and saving.
Investment, Saving,
I, S
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Macroeconomics ECO 403
VU
The classical theory of inflation
·
Inflation
­  Causes
­  Effects
­  Social costs
· "Classical" -- assumes prices are flexible & markets clear.
· Applies to the long run.
Inflation Rate in Pakistan
14
12
10
8
6
4
2
0
Years
The connection between money and prices
·
Inflation rate = the percentage increase
in the average level of prices.
·
Price = amount of money required to
buy a good.
·
Because prices are defined in terms of money, we need to consider the nature of
money, the supply of money, and how it is controlled.
MONEY: definition
Money is the stock of assets that can be readily used to make transactions.
Money: functions
1. Medium of exchange
we use it to buy stuff
2. Unit of account
the common unit by which everyone measures prices and values
3. Store of value
transfers purchasing power from the present to the future
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Macroeconomics ECO 403
VU
The ease with which money is converted into other things-- goods and services-- is sometimes
called money's liquidity.
Money: Types
1. Fiat money
·
has no intrinsic value
·
example: the paper currency we use
2. Commodity money
·
has intrinsic value
·
examples: gold coins,
Which of these is money?
a.
Currency
b.
Checks
c.
Deposits in checking accounts (called demand deposits)
d.
Credit cards
e.
Certificates of deposit (called time deposits)
The money supply & monetary policy
·
The money supply is the quantity of money available in the economy.
·
Monetary policy is the control over the money supply.
The Central Bank
·
Monetary policy is conducted by a country's central bank.
·
In Pakistan, the central bank is called State Bank of Pakistan (SBP).
To expand the Money Supply:
·
The State Bank buys Treasury Bills and pays for them with new money.
To reduce the Money Supply:
·
The State Bank sells Treasury Bills and receives the existing dollars and then
destroys them.
State Bank controls the money supply in three ways.
·Open Market Operations (buying and selling Treasury bills).
·Δ Reserve requirements.
· Δ Discount rate which commercial banks pay to borrow from the State
Bank.
35
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Macroeconomics ECO 403
VU
The Quantity Theory of Money
·
A simple theory linking the inflation rate to the growth rate of the money supply.
·
Begins with a concept called "velocity"...
Velocity
·
Basic concept: the rate at which money circulates
·
Definition: the number of times the average rupee bill changes hands in a given time
period
·
Example:
·
Rs50 billion in transactions
·
Money supply = Rs10 billion
·
The average rupee is used in five transactions
·
So, velocity = 5
·
This suggests the following definition:
V=T/M
where
V = velocity
T = value of all transactions
M = money supply
Velocity
·
Use nominal GDP as a proxy for total transactions.
Then,
V = (P x Y) / M
The Quantity Equation
·
The quantity equation
M ×V = P ×Y
follows from the preceding definition of velocity.
­  It is an identity:
it holds by definition of the variables.
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand