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Lesson 10 THE ROLE OF GOVERNMENT & MONEY AND INFLATION
If the Government increases defense, spending: G > 0, in case of big tax cuts: T < 0. According to our model, both policies reduce national saving i-e as G increases, S decreases. As T decreases, C increases and S decreases.
THE ROLE OF GOVT
The increase in the deficit reduces saving, this causes the real interest rate to rise, this reduces the level of investment.
AN INCREASE IN INVESTMENT DEMAND
Exercise Questions 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?
An increase in desired investment
r
S, I
I 1
I 2
r 1
r 2
Raises the interest rate
But the equilibrium level of investment cannot increase because the supply of loanable Funds is fixed.
S
r
S, I
I (r )
r (^1)
I (^1)
r (^2)
I (^2)
S 2 S 1
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RISE IN INVESTMENT DEMAND WHEN SAVING DEPENDS ON INTEREST RATE
An increase in desired investment raises the interest rate and raises equilibrium investment and saving.
THE CLASSICAL THEORY OF INFLATION
INFLATION
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. The term "inflation" is also defined as the increases in the money supply (monetary inflation) which causes increases in the price level. Inflation can also be described as a decline in the real value of money i-e a loss of purchasing power in the medium of exchange which is also the monetary unit of account. When the general price level rises, each unit of currency buys fewer goods and services. The basic measure of price inflation is the inflation rate, which is the percentage change in a price index over time. “Classical” -- assumes prices are flexible & markets clear. This applies to the long run.
INFLATION RATE IN PAKISTAN
0
2
4
6
8
10
12
14
1991-19921992-19931993-19941994-19951995-19961996-19971997-19981998-19991999-20002000-20012001-20022002-20032003- 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.
Real interest Rate
r
.
Investment, saving,
I ,^ S
S
A
B
I 2
1
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V = Velocity T = Value of all transactions M = Money supply If we use nominal GDP as a proxy for total transactions, then, V = (P x Y) / M
THE QUANTITY EQUATION The quantity equation can be written as: M V = P Y This equation follows from the preceding definition of velocity. It is an identity: It holds by definition of the variables.
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