What Determines the Price Level?
If the average price level is high and goods and services tend to cost a significant amount of money, consumers will demand more money. If, on the other hand. The fundamental relationship between the price level and the value of money is that, when price level goes up, the value of money goes down. Get an answer for 'As the price level falls, does the value of money fall? ' and find homework help for other Economics questions at eNotes.
This enables us to think about domestic money and prices without worrying about what is happening in the rest of the world.
Value of Money and the Price Level (With Diagram)
We will be four Lessons further along in the sequence before we look again at exchange rates, and a full understanding of how they are determined and their relationship to domestic economic policy will only emerge with completion of the entire sequence of Lessons. Nevertheless, before concluding this present Lesson we need to discuss further the law of one price and the relationship between the domestic and foreign price levels.
In order to write down Equation 2 we had to assume that all goods are produced everywhere and can be freely bought and sold across international boundaries without the impediment of transport costs, tariffs, taxes, or subsidies, so that Equation 1, the law of one price, holds for every good. Then we also assumed that each good represents the same fraction of aggregate output in each country so that countries' price indexes which are assumed to be output-weighted averages of the prices of goods produced are the same when the currencies exchange for each other on a one-for-one basis.
Of course, none of these assumptions are true, so how does the analysis change when they are false? Transport costs, taxes, tariffs and subsidies are not a problem because we can think of prices as being net of these distortions.
But many goods are not traded internationally. The classic example is haircutsone can obtain a haircut for, perhaps, 50 cents in India but the costs of flying there to obtain it are prohibitive.
Value of Money and the Price Level (With Diagram)
Since people cannot migrate freely between countries, the labour share of production represents a non-traded component of every good. This is why the price of a McDonalds hamburger, when measured in U.
Sides of beef and wheat flour can be purchased at roughly the same real price everywhere, but the labour used to make the patties, bake the bread, and provide the transport, cooking and clerical services is cheaper some places than others.
Buildings, too, are built with local labour. For these reasons a unit of aggregate output will not have the same price in all countries when measured in a single currency. The ratio of a country's price level to the price level in the rest of the world when all prices are converted into the same currency is called the country's real exchange rate.
It is the relative price of domestic output in terms of foreign output and can be written as 4. It is obvious that each country's real exchange rate will depend on which goods it produces not every good is produced in all countrieshow highly those goods are valued in world markets and on how high the productivity of domestic labour in producing domestic aggregate output is relative to the productivity of foreign labour in producing rest-of-world aggregate output.
The respective productivities of labour will determine the real costs of producing non-traded goods at home relative to abroad. In a world where technological change is occurring and all countries are not equally endowed with natural resources, it is unreasonable to expect that any country's real exchange rate will be constant through time.
The view that equilibrium real exchange rates are constant over time is called the purchasing power parity theory and it is now well-known that this theory does not hold. Nevertheless our argument that governments lose control over their money supplies when they fix the nominal exchange rate holds regardless of what determines countries' real exchange rates. Given the definition of the real exchange rate in Equation 4, the domestic price level must equal 5.
To maintain control over the domestic price level, the government must adopt a flexible exchange rate.
When conflicting domestic political forces make it impossible for the government to control the money supply it may be possible for the majority of voters to agree on a commitment to fix the price of the domestic currency in terms of the currency of some low-inflation country like the U.
The supply curve in Figure 1 is thus a vertical line positioned to the right of the vertical axis by an amount equal to the existing stock of nominal money balances in circulation. When the central bank increases the money supply this vertical line shifts rightward.
It is not, however, a straight line. The reason is that people make their decisions on how much money to hold on the basis of the real, not the nominal, quantity.
The amount of transactions that can be made with that quantity of nominal money balances will depend on the price levelif the price level were to double, the existing nominal level of money holdings would finance only half of the previous volume of transactions. People would require twice as big a nominal money stock to provide the same level of transactions services.
In other words, the amount of transactions services provided by money will depend on the real stock of money, not the nominal stock. People will thus decide on an appropriate level of real money holdings and then accumulate the stock of nominal money balances needed to provide those real holdings.
Thus, given desired real money holdings, the nominal quantity of money demanded will vary in direct proportion with the price level and in inverse proportion with the nominal value of money. Having established the shape of the demand curve for nominal money holdings, we must now think about what will determine its levelthat is, the level of desired real money holdings. One obvious factor will be the real flow of transactions, which can be roughly measured by the level of real income.
A second factor will be the cost of holding money relative to other assets. People hold money because it saves time and labour effort that would otherwise have to be devoted to arranging barter and checking other people's credit ratings. That effort could have been devoted to producing goods and services for consumption and investment. But the choice of how much money to hold, and how much labour to thereby make available for other uses, will depend on how much income will be sacrificed by holding additional money instead of other assets.
Assuming that money holdings earn no interest, that sacrifice will be the interest that could have been earned by holding bonds and other assets instead of that additional money.
As we saw in the previous Lesson, Interest Rates and Asset Valuesthe difference between the interest rates on nominal assets such as bonds and the return on real assets such as cars and TV sets will be the expected rate of inflation. This is given by the Fisher equation 1. The interest rates implicitly earned on real assets do not contain premia for expected inflation because the market value of those assets will rise with inflation along with the earnings on them.
Of course, interest is not directly earned on real assetsearnings on those assets are the streams of implicit or explicit rental income from their use. The implicit interest rate on those assets is the ratio of those earnings to their present value.
The opportunity cost of holding money instead of other assets is thus equal to the nominal interest rate. The higher the nominal interest rate, the smaller will be the desired level of real money holdings. The demand for real money holdings will also be affected by changes in transactions technology.
For example, the introduction of automatic teller machines and before them, credit cards will have made money holdings more accessible, reducing the amount of real money balances needed to effect a given volume of transactions.
Speculative shocks to desired real money holdings can also occur in response to expected future changes in nominal interest rate and the resultant capital gains or losses from holding bonds instead of money. The cause of inflation can now be easily seen from Figures 1 and 2.
A rise in the price level, or fall in the value of money, can result only from an increase in the supply of money or decline in the demand for money. While the general growth of income will increase the demand for money and improvements in the technology of making transactions will reduce it, these effects will be gradual over time. They can thus account for changes in inflation rates of only a few percentage points.