Principles of Macroeconomics Principles of Macroeconomics Module Guide K CHANDRA SAKARAN 1 Table of Contents Chapter 1 Measuring the Size of the Economy 7 Learning Outcomes 7 Introduction 8 Gross Domestic Product(GDP) 10 Computing the Real GDP and Nominal GDP 10 GDP deflator and the inflation rate 15 Real GDP and Nominal GDP Growth Rate 16 Real GDP Per Capita 17 Other Ways to Measure the Economy 17 Gross National Product(GNP) 17 Net National Product(NNP) 17 National Income at Factor Cost(NI) 18.
Cost of Living
At the end of this topic you are able to
describe the steps involved in computing the consumer price index (CPI)
compute the cost of a basket, CPI, and inflation rate
explain the limitations of CPI as a measure of the cost of living
compare and contrast between CPI and GDP deflator in measuring inflation
compute the monetary value of a particular time using the respective monetary value and price indices
explain the importance of computing the CPI
compute the real interest using the nominal interest rate and the inflation rate
The cost of living is a significant concern for society, representing the expenses associated with maintaining a specific standard of living It is determined by calculating the average costs of a basket of goods and services typically consumed by households.
The rising cost of living significantly impacts households, businesses, and the government For households, it necessitates earning more to maintain living standards, often leading to longer work hours and increased demands for higher wages, which can reduce family time and overall quality of life Businesses face pressure as trade unions push for wage increases, potentially raising production costs unless productivity rises correspondingly, which may lead firms to explore alternative production methods, risking unemployment The government is also concerned, as the escalating cost of living can adversely affect employment, trade, and investment, prompting the need for effective policy responses to address these challenges.
Measuring the Cost of Living
Measuring the cost of living involves four key steps First, a basket of goods and services commonly consumed by an average household is established After fixing the basket, the prices of these items are determined Next, the total cost of the basket is calculated, which is then utilized to compute the consumer price index (CPI) based on a designated base year Finally, the CPI serves as a crucial tool for assessing the inflation rate.
In a hypothetical basket of goods, there are 10 loaves of bread and 5 units of apples The accompanying table outlines the prices of both bread and apples during the specified time period.
Year Price of bread per loaf Price of apple per unit
The cost of the basket(2013) = ($2 x 10) + ($4 x 5) = $40 The cost of the basket(2014) = ($2.50 x 10) + ($4.50 x 5) = $47.50 The cost of the basket(2013) = ($3.10 x 10) + ($5.50 x 5) = $58.50
Basket of goods and services
Prices of goods and services
The Consumer Price Index (CPI) is a key indicator used to estimate price changes in a basket of goods and services that reflect the consumption expenditure of an economy It measures the total cost of goods and services purchased by an average household To calculate the CPI, a stable base year is selected for comparison An increase in the CPI indicates rising overall prices, while a decrease signifies falling prices for goods and services.
Cost of basket(Base year)x 100 = $40.00 $40.00 x100 = 100
Cost of basket(Base year)x 100 = $47.50 $40.00 x100 = 118.75
Cost of basket(Base year)x 100 = $58.50 $40.00 x100 = 146.25
Inflation refers to the ongoing rise in the general prices of goods and services within an economy The inflation rate indicates the percentage change in the price index compared to the previous period.
The inflation rate is determined by comparing the Consumer Price Index (CPI) between two time periods A positive inflation rate signifies that the overall prices of goods and services are increasing, while a negative inflation rate, known as deflation, indicates that these prices are decreasing.
Inflation rate for 2014 = CPI(2014)−CPI(2013)
The prices of goods in the basket in 2014 on average has increased by 18.75% compared to the price in 2013
Inflation rate for 2015 = CPI(2015)−CPI(2014)
The prices of goods in the basket in 2015 on average has increased by 23.16% compared to the price in 2013
Limitations of CPI as a Measure of Cost of Living
CPI is measured based on a fixed basket of goods and services over time, resulting in the CPI being overstated This can be explained the following reasons:
Introduction of new product bias
Substitution bias occurs because the Consumer Price Index (CPI) fails to account for consumers' tendency to shift towards relatively cheaper goods over time By relying on a fixed basket of goods and services, CPI assumes that consumers will maintain their purchasing levels despite rising prices In practice, however, consumers tend to buy less of the more expensive items, resulting in overall expenses that are lower than what the CPI indicates.
Introduction of new product bias occurs because the basket of goods and services are not revised
The Consumer Price Index (CPI) faces challenges in accurately reflecting the cost of living, as it relies on a fixed basket of goods and services that does not account for new products and technologies As consumers increasingly opt for innovative goods and services that offer better value, the CPI fails to capture these shifts, leading to an inaccurate representation of the true cost of living for the average consumer.
The Consumer Price Index (CPI) struggles to accurately measure quality changes in products, often overlooking the benefits consumers gain from higher-quality goods By relying on a fixed basket of goods for calculations, the CPI assumes that product quality remains constant Consequently, when a product's price increases due to enhanced quality, the CPI mistakenly attributes this rise to inflation As a result, inflation indices inadequately consider the impact of quality improvements on pricing.
The Consumer Price Index (CPI) and the GDP deflator are essential tools for measuring inflation The GDP deflator is determined by dividing nominal GDP by real GDP and multiplying the result by 100 In contrast, the CPI is calculated based on a selected sample of consumer goods and services included in a designated basket.
1 Involve only consumer goods and services
Involve all final goods and services Final goods consist of consumer goods and capital goods
2 Involve imported and domestically produced consumer goods and services
Involve only domestically produced goods and services
3 CPI compares the prices of a fixed basket of goods over time
The GDP deflator measures the current prices of goods and services against those from a base year, reflecting changes in the economy over time As production levels fluctuate, the basket of goods and services used to calculate the GDP deflator automatically adjusts, providing an accurate representation of inflation and economic growth.
Correcting Economic Variables for the Effects of Inflation
Comparing monetary values from different time periods requires adjusting for inflation using a price index, as the purchasing power of money changes over time To determine the present worth of a specific amount of money from the past, it is essential to apply these price indices for an accurate comparison.
Samuelson annual salary in Year 1 was $120,000 and the price index in Year 1 was 105 What is Samuelson’s Year 1 annual salary in Year 2 if the price index in year 2 is 110?
Samuelson’s Year 1 salary in Year 2
Annual Salary in Year 2 = Annual salary Year 1 x Price Index Year 2
CPI and GDP Deflator (Malaysia)
In 1960, Roberto earned an annual salary of $40,000 with a price index of 45, while his grandson, in 2015, earns $150,000 for the same job, with a price index of 135 To determine if Roberto's grandson is better off, we need to compare their real incomes adjusted for inflation.
Roberto’s grandson earns more than Roberto
The percent change in the Consumer Price Index (CPI) serves as a key indicator of inflation, benefiting various economic sectors, including households, firms, and government Households can utilize the CPI to negotiate salaries or wages, while firms assess the CPI to evaluate the business environment in a country, as high inflation can deter investment due to increased costs Meanwhile, the government can leverage this inflation data to formulate effective economic policies to mitigate the impact of rising prices.
Production and Growth
At the end of this topic, you are able to
list the countries with the highest gdp per person and the countries whose
GDP per person is growing the fastest
explain why production limits consumption in the long run
list and explain the factors of production
explain seven areas of policy action that may influence a country’s productivity and growth
Economic prosperity varies widely across the globe and is primarily measured by real GDP per capita Two main factors influence a nation's economic prosperity: the level of economic productivity and the size of its population Additionally, the real GDP per person is determined by both the economic growth rate and the population growth rate.
GDP Purchasing Power per capita(PPP) and economic growth rate between countries
GDP purchasing power parity (PPP) per capita is a key indicator for assessing the living standards of a country's population By comparing GDP at PPP per capita, we can better understand the overall differences in living standards across nations, as this measure considers the relative cost of living and inflation rates, rather than relying solely on exchange rates, which can obscure true income disparities.
Luxembourg, Norway, and Qatar consistently rank among the top three richest nations globally, primarily due to their high GDP per capita (PPP) As of 2015, Luxembourg leads with an impressive GDP per capita of over US $110,697.00, followed closely by Norway at more than US$100,818.50 Qatar ranks third, with a GDP per capita nearing US $93,714.10, showcasing the economic strength of these small economies.
2015(Expatistan and The World Bank,2015)
The world poorest based on the same indicator is Malawi with the US $226.50 in 2015 followed by Burundi (US$267.10) and the Central African Republic(US$333.20) (World Bank,2015)
Between 2006 and 2015, Qatar achieved the highest average GDP growth rate at 13%, followed by Turkmenistan at 11% and Ethiopia at 10.2%, according to the International Monetary Fund (IMF) In contrast, among the 189 tracked countries, San Marino, Greece, the Central African Republic, and Italy experienced the lowest average growth rates, with declines of -1.5%, -1.4%, -0.6%, and -0.4% respectively, largely due to the global downturn that began in 2007 Additionally, South Sudan recorded the steepest average GDP decline at -3.4%, reflecting the challenges faced during its early development.
Economic productivity is a key factor that determines the ability to produce goods and services, directly influencing the standard of living A higher level of productivity leads to improved living standards, as it measures the output generated per unit of input, which includes labor and capital Essentially, productivity is defined as the ratio of output volume to the volume of inputs, highlighting its critical role in economic growth and quality of life.
The four key determinants of productivity include physical capital, which refers to the equipment and structures utilized in the production of goods and services; human capital, encompassing the knowledge and skills gained by workers through education, training, and experience; natural resources, which are the raw materials provided by nature for production; and technological knowledge, representing society's understanding of optimal production methods.
The production function illustrates the connection between production (Q) and its inputs, which include labor (L), human capital (H), physical capital (K), technological knowledge (T), and new resources.
Labor dynamics are influenced by the growth of labor supply and productivity, which are affected by factors such as average hours worked per employee, the employment-to-population ratio, and the growth of the working-age population Human capital plays a crucial role in production, encompassing both the quantity of labor hours and the quality of the workforce, which can be improved through development initiatives Migrant workers serve as valuable new labor resources, significantly increasing production capacity; for instance, Malaysia employs around 4 million migrant workers, boosting its goods and services output Additionally, enhancing human capital through training, education, and experience equips workers with new skills that elevate their productivity Labor productivity is quantified by the total output divided by the labor hours utilized in production.
Physical capital encompasses investments in modern machinery and equipment that enhance production efficiency By utilizing advanced tools, labor productivity can significantly increase Capital productivity is measured by the ratio of output produced to the capital available for labor Furthermore, technological knowledge plays a crucial role in discovering and applying new technologies, which further boosts productivity by optimizing the production of goods and services.
The labor productivity depends on the amount of capital and resources available for each worker
Labor productivity is influenced by the ratio of physical capital per worker (K/L), the level of human capital per worker (H/L), and the availability of natural resources per worker (N/L).
Increasing labor in relation to a fixed amount of capital leads to diminishing marginal returns, where production rises but at a decreasing rate In contrast, when both labor and capital increase, the production curve shifts upward Poor economies often operate with minimal capital, resulting in low productivity; however, providing additional capital can significantly accelerate their growth Conversely, wealthy economies, which already utilize substantial capital, experience only marginal growth from further capital investments This phenomenon is illustrated by the catch-up effect theory, which posits that poorer economies tend to grow faster than richer ones, suggesting that all economies will eventually converge in per capita income over time.
Economic Growth and Public Policy
The economic growth of a country can be referred as the economy’s capacity to increase the productivity of services and goods in comparison with the previous time period
Recent studies highlight several key factors that drive growth and development, including investments in physical capital, education, and human capital Additionally, advancements in technology and knowledge, along with infrastructure investments and international trade, play a crucial role in fostering economic progress.
Public investments play a crucial role in building public capital, encompassing various types such as education, infrastructure, physical assets, technology, and human resources By strategically investing in these sectors, significant economic benefits can be achieved, leading to enhanced growth and development.
Infrastructure investments, such as roads, bridges, water supplies, sanitation, and public health and education facilities, play a crucial role in economic development and quality of life By improving infrastructure and transportation systems, communities can unlock numerous benefits, including increased job creation and tourism, ultimately giving a significant boost to the local economy.
Investing in education is crucial as it fosters positive learning experiences that lead to superior educational outcomes These enriching experiences not only enhance future learning but also boost earning potential and overall quality of life Similarly, investments in human capital can yield significant benefits By enhancing public capital, we can improve the production of marketable goods, increase food production, and further develop human capital, ultimately driving economic growth and societal advancement.
Investments made in technology encourage innovation, which is at the core of economic growth and development
Saving, Investment, and Economic Growth
Saving, Investment, and Financial System
At the end of this topic, you are able to
list and describe four important types of financial institutions
describe the relationship between national saving, government deficits, and investment
explain the slope of the supply and demand for loanable funds
explain the shift of the supply and demand curves in a model of the loanable funds market in response to a change in taxes on interest or investment
discuss the shift of the supply and demand curves in a model of the loanable funds market in response to a change in the government’s budget deficit
The financial system is comprised of diverse institutions, including the bond market, stock market, banks, and mutual funds These entities utilize household savings to offer loans to both households and businesses, effectively matching savings with investment opportunities.
The financial system in Malaysia is composed of financial institutions and financial markets, with the banking system and non-bank financial intermediaries playing crucial roles The banking sector includes the central bank, commercial banks, merchant banks, and various institutions like discount houses and credit guarantee corporations Meanwhile, non-bank financial intermediaries consist of provident and pension funds, development financial institutions, and savings institutions such as the national savings bank, co-operative societies, unit trusts, Cagamas Bhd, and leasing companies.
Factoring companies, Pilgrims Fund Board
The financial markets consist of financial institutions through which savers can directly provide funds to borrowers.The financial market in Malaysia comprises of :
Money and foreign exchange markets
Capital markets entail the equity and bond market The bond market consists of public debt securities and private debt securities
Derivative markets – commodity futures, Bursa Malaysia (KLSE), KLIBOR Futures
Offshore markets- Labuan International Offshore Financial Centre
Most of the banking institutions are involved in the money and foreign exchange (forex) market and in the capital market
The Bond Markets (Public debt securities and Private debt securities)
A bond is a certificate of indebtedness issued by firms and governments to raise capital from savers, categorized into private or public bonds Newly issued bonds are traded in the primary market, while existing bonds are bought and sold in the secondary market Each bond specifies a maturity date and offers periodic interest payments until it matures A key factor influencing a bond's value is its term, which is the duration until maturity Additionally, the credit risk associated with the bond plays a crucial role in determining the interest rate; higher credit risk leads to higher interest rates due to the increased likelihood of default on interest or principal payments.
The banking system in Malaysia is composed of both monetary and non-monetary institutions, with monetary institutions including the central bank, Bank Negara Malaysia, and various commercial banks.
The non-monetary institutions are closely linked to the monetary institutions, which include the Merchant Banks, Discount Houses, and the Credit Guarantee Corporation
Non-bank financial intermediaries (NBFIs) play a crucial role in the financial sector, with provident, pension, and insurance funds forming the largest group within this category These funds mobilize resources from members through contributions and insurance premiums, providing essential long-term, non-inflationary financing for the public sector While provident and pension funds operate as non-profit entities focused on benefiting their members and beneficiaries, insurance companies function as profit-driven institutions that offer protection against potential losses related to property, income, or life in exchange for a fee.
The concept of loanable fund refers the total amount of money in an economy
Loanable fund market is where people or entities decided to save and lend out to borrowers as an investment
The loanable fund market is driven by the interaction between savers and borrowers, where savers provide the supply of loanable funds and borrowers generate the demand This dynamic establishes the foundational supply and demand model within the financial system.
This model can be used to examine the impact of government policies on the saving, investment, and the interest rate
This analysis operates under the premise of a unified financial market where all savers invest their savings and all borrowers secure loans In this market, a single interest rate serves as both the return on savings and the cost of borrowing, creating a streamlined financial environment.
The supply of loanable = Saving
Total savings in a closed economy encompass both private and public savings Private savings are influenced by household income, which includes transfer payments, taxes, and consumption levels Households save for various purposes, such as investing in bonds, shares, unit trusts, or tangible assets like residential properties and cars, as well as to earn interest on their savings.
Private saving = Income(Y) – Tax(T) – Consumption(C )
In a fictional economy, households earn a total income of $10 million, with income tax payments amounting to $2 million Household consumption expenditure stands at $4 million, while government purchases contribute $1 million to the economy.
Based on the above information, the economy, private saving is $4 million
The public saving depends on the tax revenue and government expenditure
If the T > G represents a positive public saving, which indicates a surplus budget In the case of
T < G represents a negative public saving indicating a deficit budget
The national saving in a closed economy consists of the private and public saving
Private saving = Income(Y) – Tax(T) – consumption(C ) Private saving = $10m - $2million - $4million = $4million
Public saving = Tax (T) – Government expenditure (G)
Public saving = $2million – $1 million = $1million
National saving = Private saving + Public saving National saving = (Y – T – C) + (T – G)
National saving = Y – C – G = $10 million - $4 million - $1 million =$5 million
Suppose in a closed economy the GDP is equal to $11,000, taxes are equal to $2,500
Consumption equals $7,500 and Government purchases equal $2,000.What is private saving, public saving, and national saving?
Suppose in a closed economy the GDP is $11,000, consumption is$ 7,500, and taxes are $2,000
What value of Government purchases would make national savings equal to $1000 and at that value would the government have a deficit or surplus?
Investment (I) in the study of economics refers to the acquisition of goods that are not consumed today but are used in the future to create wealth Examples of investment:
• Help University spends $250 million to build a new campus at Subang
• You buy $5000 worth of computer equipment for your business
• You spend $300,000 to purchase a new condominium
An investment in a closed economy can be determined using the national income accounting identity
Total investment is directly linked to national saving, meaning that any increase in national income or a reduction in household consumption or government spending will boost national saving and, consequently, total investment.
The Supply of Loanable Fund Curve
The supply of loanable funds is derived from savings, which consist of both private and public savings This supply is directly influenced by interest rates; as the real interest rate rises, the quantity of loanable funds supplied also increases, encouraging individuals to save more for better returns Additionally, if households reduce their spending from disposable income, the supply of loanable funds will further increase Public saving is contingent on the government's budget; a deficit budget results in negative public savings, thereby decreasing national savings, while a surplus budget enhances public savings and boosts national savings.
An increase in the real interest rate enhances the appeal of saving, leading to a rise in the quantity of loanable funds supplied For instance, the quantity supplied of loanable funds increased from $30 million at a 3% real interest rate to $45 million at a 6% rate This change in interest rates results in an upward movement along the supply curve Additionally, the supply curve for loanable funds can shift due to factors such as government policies affecting savings, changes in the government budget, household preferences for saving, and variations in national income.
An increase in the government budget surplus will increase the public saving and national saving This event will shift the supply of loanable fund curve to the right to S1S1
In the above figure, the quantity supplied of loanable was $30 at a real interest rate of 3% and it increases $45 million due to an increase in the government budget surplus
The following table summarizes the determinants of the supply of loanable fund
Determinants Supply of loanable fund increases
Supply of loanable fund decreases
An Increase in national income Ѵ
An increase in government budget surplus or decrease in government budget deficit Ѵ
A decrease in government budget surplus or increase in government budget deficit Ѵ
An increase in the households attitude towards saving Ѵ
A decrease in the attitude towards saving Ѵ
Borrowers create the demand for loanable funds, which includes household borrowers seeking auto loans, home mortgages, and installment credit, as well as businesses engaging in corporate borrowing, farm credit, and trade credit Corporations typically finance their borrowing by issuing interest-bearing financial assets like corporate bonds, while governments often fund specific projects, such as school construction, through the sale of government bonds Ultimately, the demand for credit is driven by two main components: the direct demand for credit through loan applications and the financing needs of various borrowers.
30 45 consumers, for example) and, (2) the sale of all classes of interest-bearing financial assets as a means to raise money
The determinants of demand for loanable funds are the real interest rate, investors’ confidence, household’s confidence, and income and government policy related to investment
To construct the demand for loanable funds curve, it is essential to allow only the real interest rate to change while keeping other factors constant For borrowers, the real interest rate signifies the cost of borrowing; as this rate rises, the cost of borrowing also increases, leading to an upward movement along the demand for loanable funds curve.
The downward sloping demand curve for loanable funds indicates a negative correlation between the real interest rate and the quantity demanded Specifically, the quantity of loanable funds demanded in the economy is $45 million at a 3% real interest rate, which decreases to $30 million when the real interest rate rises to 6%.
Monetary System
At the end of this topic, you are able to
define money and list and explain the three functions of money
distinguish between fiat money and commodity money
distinguish between M1 and M2 definition of money supply
explain the role of the central bank in money creation
explain the money multiplier in a fractional reserve banking system
list and explain the three tools central banks use to change the money supply
identify and explain the problems controlling the money supply
A monetary system is an essential framework established by a government to manage the supply of money within its economy It typically includes a central bank and commercial banks, which work together to facilitate financial transactions The advent of money has significantly improved upon the limitations of the barter trade system, leading to increased efficiency and enhanced economic interactions.
Money and the Functions of Money
Money is an accepted medium for payment and settling economic debts, characterized by its acceptability, scarcity, durability, portability, and divisibility.
Money serves four essential functions: it acts as a medium of exchange, a unit of account, a store of value, and a standard for deferred payments As a medium of exchange, money facilitates the purchase of goods and services, exemplified by spending $20 to watch a movie Without money, acquiring desired goods would be challenging, as trade would rely solely on barter, which involves the direct exchange of goods between parties.
55 person whose wants coincide The main issue with barter trade is the double coincidence of wants
The second function of money is serving as a unit of account, which allows individuals, businesses, and governments to accurately record and track all transactions This capability enables firms to assess their expenditures, revenues, and profits effectively For instance, when dining at a restaurant, the menu prices—such as a hamburger costing $5 and a steak costing $15—illustrate how money functions as a unit of account.
People save money in banks primarily because it acts as a store of value, enabling them to defer spending for future needs This function allows individuals to trade off current consumption for future consumption While money retains its nominal value whether kept at home or in a bank, its real value diminishes due to inflation, which can erode purchasing power over time.
Money plays a crucial role in calculating loan installments for significant purchases like cars or houses, acting as a standard for deferred payments For instance, if you take out a hire purchase loan for a $50,000 car over five years with a 10% annual interest rate, your monthly installment would amount to $1,250.
Liquidity means the ease an asset can be converted into the economy’s medium of exchange
Money serves as the most liquid asset, functioning primarily as a medium of exchange There are two main types of money: fiat money and commodity money Fiat money, which includes coins and notes, is recognized as legal tender by the government, making it widely accepted, despite lacking intrinsic value.
Commodity money is money whose value comes from a commodity of which it is made
Commodity money refers to items that possess intrinsic value both as goods and as a medium of exchange Examples include gold, silver, and even cigarettes, which have historically been utilized as currency However, a notable drawback of commodity money is its unpredictable supply, which can lead to fluctuations in value and may influence people's willingness to use it.
56 produce money and hence affecting the supply of money Inflation may happen if the supply of money goes out of control, which may adversely affect the value of money
A central bank is crucial for ensuring a stable financial system, which is essential for a healthy economy In Malaysia, this institution is referred to as Bank Negara Malaysia, while in the United States, it is known as the Federal Reserve Bank (Fed).
A central bank serves five key roles: it functions as the banker for the central government, provides banking services to commercial banks, regulates the banking sector, implements monetary policy, and ensures the stability of the financial system.
As the government's banker, the central bank manages deposit accounts, facilitates domestic and international currency transactions, and offers related advice Similar to how corporations and individuals utilize commercial banks, the government maintains deposit accounts at the central bank for receiving funds, executing payments, and clearing checks.
The central bank serves as a banker to commercial banks by maintaining their deposit accounts, which facilitate interbank transactions and meet cash reserve requirements Acting as a lender of last resort, the central bank provides liquidity to banks facing shortages, thereby preserving public confidence in the banking system This assurance prevents panic withdrawals and encourages individuals to trust their savings in banks Additionally, the central bank is responsible for establishing and maintaining a Clearinghouse for cheque transactions.
The central bank serves as a key regulator of banks, focusing on promoting financial stability by ensuring the safety and soundness of financial institutions This includes maintaining the integrity and orderly functioning of money and foreign exchange markets, as well as establishing safe, efficient, and reliable payment systems Additionally, the central bank aims to uphold fair and responsible business practices among financial institutions while protecting the rights and interests of consumers using financial services and products To achieve these objectives, legislation is in place to regulate and supervise financial institutions, payment system operators, and participants in the money and foreign exchange markets.
The central bank's primary role is to manage the money supply within the economy, which comprises the total amount of government-issued currency and reserves held by commercial banks It exercises strict control over this monetary base using various tools, including open market operations for buying and selling government securities, adjusting the discount rate, and setting reserve requirements.
A central bank plays a crucial role in regulating the growth of the money supply within an economy, as an increase in this supply can lead to inflation Money supply can be defined in two ways: the narrow definition includes only those items that serve as a medium of exchange, while the broad definition encompasses items that function both as a medium of exchange and a store of value.
Money Growth and Inflation
At the end of this topic, you are able to
demonstrate the link between money and prices with the quantity equation
explain the factors influencing the money demand and money supply
describe the money market equilibrium and factors causing the changes to the money market equilibrium
analyze the effects of money injection to the interest rate, price level, and real GDP in the short run and long run
explain classical dichotomy and monetary neutrality
explain why money has no impact on real variables in the long run
explain the concept of an inflation tax
show the relationship between the nominal interest rate, the real interest rate, and the inflation rate
explain who gains and who loses on a loan contract when inflation rises unexpectedly
Central banks prioritize inflation control as a key aspect of their mandate, primarily focusing on managing money supply to ensure price stability The inflation rate is typically assessed through metrics like the consumer price index (CPI) and the GDP deflator The CPI specifically tracks the cost of living by measuring the price changes of a fixed or periodically adjusted basket of goods and services, providing essential insights into consumer purchasing trends.
(2010 = 100) in Malaysia was 112.81 as of 2015 As the graph below shows, over the past 10 years, this indicator reached a maximum value of 112.81 in 2015 and a minimum value of 100 in
Source: International Monetary Fund, International Financial Statistics and data
The Classical Theory of Inflation
The classical theory of inflation asserts that a persistent rise in prices is primarily driven by excessive growth in the money supply This concept is often referred to as the "quantity theory of money," highlighting its focus on inflation rather than on the broader implications of money itself.
The persistent increase in the overall price level negatively affects the value of money, as they are inversely related; when prices rise, the purchasing power of money decreases, allowing it to buy fewer goods and services Conversely, a decrease in the price level enhances the purchasing power of money, enabling it to acquire more goods and services Therefore, the value of money fluctuates inversely with changes in the price level.
The value of money stems not from its physical form, such as a dollar bill being merely paper and ink, but from its purchasing power, which surpasses that of other similar pieces of paper This intrinsic power is derived from various economic factors that establish trust and stability in the currency.
In economics, the money market operates like any other market, where the supply of money is primarily controlled by the central bank This institution holds the authority to modify the money supply, influencing economic conditions and financial stability.
67 by increasing or decreasing the number of bills in circulation Nobody else can make this policy decision The demand for money in the money market comes from consumers
The value of money is subject to fluctuations as indicated by the money market, influenced by changes in money demand or money supply These alterations lead to corresponding changes in both the value of money and the price level, with their variations being equal in magnitude but opposite in direction.
Income (Y) Price of Bread Quantity of bread Value of money
As the price of goods and services rises from $2 to $4 per unit, the purchasing power of $1 decreases, illustrating the inverse relationship between price and the value of money, where the amount of goods that can be acquired for $1 drops from 1/2 to 1/4.
Determinants of the Price Level
Changes in the price level are caused by two factors:
(a) Changes in the money market, and
(b) Changes in the goods and services market
Changes in the Money Market: Changes in the Money Supply
When a country increases its money supply, such as by printing new currency, it provides people with more funds for purchasing goods and services This rise in purchasing power leads to an increased demand for goods and services, which subsequently boosts aggregate demand in the market As aggregate demand rises, it results in an increase in the overall price level.
A decrease in the money supply leads to reduced purchasing power, resulting in a decline in price levels Similarly, an increase in the supply of goods and services typically causes prices to drop, while a decrease in their supply tends to drive prices up.
Money market equilibrium is shaped by the interplay between the demand for money and its supply The demand for money reflects the desire to hold financial assets in cash form, driven by three primary motives outlined in Keynes' Liquidity Preference Theory: the transaction motive, which pertains to the need for money to purchase goods and services; the precautionary motive, which involves holding cash for emergencies; and the speculative motive, which is the desire to have cash available for potential investment opportunities Various factors, including income levels, interest rates, inflation, and future uncertainties, influence the demand for money, aligning with these three motives.
The demand for money for transactions (L T) is directly influenced by fluctuations in price levels and income As prices or income rise, individuals tend to increase the amount of money they hold for transactional purposes.
Money demand for precaution (L P ) is also directly affected by a change in income level When income increases, the money people hold for precaution will increase
The demand for speculative money (LS) is negatively correlated with interest rates; as interest rates rise, bond prices decline, prompting speculative investors to allocate their funds towards purchasing bonds.
Money demand (MD) = Liquidity preference (LP) = L T + L P + L S = f (Y, P, r)
The changes to the amount of money are caused by a change in the quantity demanded for money or a change in the demand for money
The change in the interest rate directly affects the demand for money, as an increase in interest rates leads to a decrease in the quantity demanded for money This is because speculative money is redirected towards purchasing bonds Consequently, the shift in quantity demanded for money is represented by an upward movement along the money demand curve.
Suppose the interest rate is 5 %, the quantity demanded for money is $10b and if the interest rate increases to 7%, the quantity demand for money decreases to $6b
Changes in price or income lead to fluctuations in money demand, with increases in either factor resulting in a rightward shift of the money demand curve For instance, if the initial money demand curve, labeled MD, reflects a total demand of $10 billion at a 5% interest rate, an increase in price or income will elevate the demand for transactions, shifting the curve to MD1 Consequently, this adjustment indicates a higher total demand for money.
A $20 billion amount at a 5% interest rate indicates that if prices or income decline, the money demand curve will shift leftward to MD2 Consequently, the overall demand for money will decrease to $6 billion at the same 5% interest rate.