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Money Supply, Inflation, and Unemployment

Money Supply, Inflation, and Unemployment. Inflation Rate in Long Run. MV = PY So… % Δ M + % Δ V ≅ % Δ P + % Δ Y M = Money Supply V = Money Velocity P = Price Level Y = real GDP. Inflation Rate in Long Run. Since Velocity tends to remain culturally constant,

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Money Supply, Inflation, and Unemployment

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  1. Money Supply, Inflation, and Unemployment

  2. Inflation Rate in Long Run MV = PY So… %ΔM + %ΔV ≅ %ΔP + %ΔY • M = Money Supply • V = Money Velocity • P = Price Level • Y = real GDP

  3. Inflation Rate in Long Run Since Velocity tends to remain culturally constant, %ΔM + 0 ≅ %ΔP + %ΔY Or %ΔM ≅ %ΔP + %ΔY Or, to understand inflation… %ΔP ≅ %ΔM — %ΔY • M = Money Supply • V = Money Velocity • P = Price Level • Y = real GDP

  4. LRAS and Inflation • This explains why the European Central Bank focuses their analysis on money supply • If rGDP grows by 2 or 3% per year, then %ΔM reliably determines inflation %ΔP ≅ %ΔM — %ΔY %ΔP ≅ %ΔM — 3% • M = Money Supply • V = Money Velocity • P = Price Level • Y = real GDP

  5. Unemployment: Reservation Wage • Employees want the highest wage possible • Employers generally want to pay the least required (but not always) • As time unemployed lengthens, employees are willing to take lower wages, but are likely to find higher wage possibilities

  6. US Unemployment Rate

  7. Unemployment: Reservation Wage Wage BOR • Government policy can affect wages and unemployment duration • Welfare and unemployment relief payments extend duration • Effect on wages and duration? RW2 RW1 Duration of Search

  8. Unemployment: Reservation Wage Wage BOR1 BOR2 • Faster and more complete spread of information can lead to higher BoR • Monster.com and other Internet sites increase job vacancy awareness • Effect on wages and duration? RW2 Duration of Search

  9. Unemployment: Reservation Wage Wage BOR2 BOR1 • What is the effect of the comb-ination of unemployment payment policy and increased spread of information? • Effect on wages and duration? RW2 RW1 Duration of Search

  10. Scenario 1 • The government, faced with rising budget deficits, decides to limit unemployment payments to only 4 weeks. • What is the effect on output, rGDP, and Price Level? (Use which graph?) • What is the likely effect on wages and the typical duration of search for a worker?

  11. Scenario 2 • ECB statistics show that the money supply is increasing by 8%. rGDP is increasing by 3%. • What is the expected inflation rate? • What monetary policy should the ECB take to redress the situation? • What effect will this policy have on the value of the US dollar relative to the euro?

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