The Circular Flow of Economic Activity, Aggregate Demand, and Inventories
Econ 101b: Quantity of Money Problem Set

The Price Level in the Medium Run: Background and the Quantity Theory Model

The Price Level in the Medium Run: Background and the Quantity Theory Model

J. Bradford DeLong

February 2008

The U.S. experienced an episode of relatively mild inflation--prices rising at between five and ten percent per year--in the 1970s. Although relatively mild, that inflation was large enough to cause significant economic and political trauma. Avoiding a repeat of the inflation of the 1970s remains a major goal of economic policy even today, a quarter century later.

Many countries have experienced inflations that are not mild. In Russia in 1998 the price level rose at a rate of 60 percent per year. In Germany in 1923 prices rose at a rate of 60 percent per week. In Zimbabwe last month price tripled in a day. Such so-called *hyperinflations have been seen in many other countries: from Argentina to Ukraine, from Hungary to China. They are extremely destructive. They inflict severe damage on the ability of money to grease the wheels of the social mechanism of exchange that is the market economy. The system of prices and market exchange breaks down, and production can fall to a small fraction of potential output.

In the medium run model we analyze real economic quantities withought ever having to refer to the price level or the inflation rate. This is a special feature of the model, this classical dichotomy: the fact that real variables (like real GDP, real investment spending, or the real exchange rate) can be analyzed and calculated without thinking of nominal variables like the price level. You will also hear economists speak of this as the property that "money" is neutral, or that "money" is a veil--a covering that does not affect the shape of the face underneath.

Now it is time to turn to the question of the price level and inflation in the medium-run model. This is worth doing for two reasons. First, it provides a useful baseline analysis against which to contrast the conclusions of future chapters. Second, whenever we look over relatively long spans of time—three to five years or more, perhaps—wages and prices are effectively flexible, they do have time to move in response to shocks, and the flexible-price assumption is a fruitful and useful one.

First, some underbrush: when normal people use the word "money," they may mean a number of things. "Money" may be used as a synonym for wealth: when we say "she has a lot of money," we mean that she is wealthy. "Money" may be used as a synonym for income: when we say "he makes a lot of money," we mean that he has a high income.

Economists, however, are not normal. When an economist uses the word "money," he or she means something different. To an economist, "money" is wealth that is held in a readily-spendable form. Money is that kind of wealth that you can use immediately to buy things because others will accept it as payment... continued