Money and Inflation
real variables vs. nominal variables? (different from real and
nominal value)
Classical Dichotomy?
Recall: the definition of Inflation
Long run vs short run?
The Money Market
Qty of money demanded: is the amount of money that
households and firms choose to hold.
n.b: the price of money is the nominal interest rate and represents
the opportunity cost of holding Money.
recall the diff. b/t nominal and real interest rate
Conceptual ex.
Suppose you have $100 in pocket, what would you do if the
nominal interest rate is 2% vs. 25%.
Would that decision change if that change is due to inflation versus
the real interest rate?
Changes in the Demand for Money (shifters)
1) Change the in the general price level (+)
2) Change in real GDP (+)
3) Change in Financial technology (Could go in either direction)
Ex) Debit cards vs. credit cards:
Money Supply
The money supply is perfectly inelastic. (what does this mean?)
It is fixed and determined by FED policy.
Question:
1) List and describe the three policy tools used by the FED to control
the money supply.
2) What is the money multiplier? What factors influence the size of the
multiplier and how?
ex. If the current nominal interest rate is 6%, and the money market
equilibrium int. rate is 4%. Analyze what happens in the money
market. In your response
i)state whether persons buy or sell bonds. Explain the logic.
Examples
Ex. Analyze the money market after a monetary injection by the FED.
In your response describe
i) how the FED may conduct a monetary injection.
ii) what happens to the money supply
iii) what persons decide to do with commercial paper
iv) The equilibrium nominal interest rate and quantity of money.
Ex. Suppose a change in bank regulation increased the availability of
credit cards (ex Delaware Act 1981) .
i) Analyze how the money market is impacted?
ii) Identify two tools of the FED to stabilize interest rates.?
The Money Market in the Long Run
Idea is that money market determines prices in the long run. How?
Point- Nominal interest rate is fixed in the long run.
Scenario: The Fed conducts policy and lowers the bank reserve
requirement . Evaluate the impact in the money market in the short
run and long run.
Steps- short run
1) Which curve shifts and in what direction?
2) What decision do persons make at the original interest rate?
3) Describe the new equilibrium interest rate and quantity of money.
Long run
4) How does the lower interest rate impact spending and prices?
5) What is the final equilibrium interest rate and quantity of money?
The Quantity Theory of Money
Quantity theory of money: when real GDP equals potential GDP, an
increase in the quantity of money brings an equal percentage increase
in the price level (other things remaining the same).
• The velocity of circulation = V -- the number of times a $ circulates
• The quantity of money = M
• The price level = P
• Real GDP = Y
the equation of exchange is
MV=PY
(1)
We can derive an equation for Price, and the inflation rate.
P=( M x V)/Y
Infl.= growth rate of money+ velocity growth rate – growth rate RGDP
Lets see this in action
Ex) if an economy sells pizza for $10, the quantity of money in the
economy is $50, and a dollar passes hands an average of 20 times in a
year.
1)How many pizzas are produced output if all resources are used?
2)What is the value of nominal GDP?
Ques: If the real interest rate is fixed what does this mean for the
nominal interest rate, and the quantity of money demanded?
Practice questions.
1) How is the price of a financial asset, such as government bonds, related to the
nominal interest rate?
2) Suppose the quantity of money is greater than the quantity of money demanded.
With words and in diagrams describe the adjustment in the money market in the long
run and short run?
3) A government policymaker suggests “Double the money supply and U.S. citizens’ real
incomes will double.” In the long run, is this policy advice correct? Which variable is
changed in the long run?
5) What is the best explanation for differences in nominal interest rates between
countries? (Hint recall how the global market determines the real interest rate)
6) Suppose the Fed sells government bonds. Use a graph of the money market to show
what this does to the value of money. How does your response relate to the change
in the price level which occurs?
THE COST OF INFLATION
Ex. If an economy remains at full employment. What is the inflation rate
if velocity growth is 1% and the FED increases money by 1% each
year?
Defn: Hyperinflation- An inflation rate that exceeds 50 percent a month.
Ques: Why is inflation bad?
For the macro-economy is rising cost of living necessarily bad?
(Hint- imagine a country with only one family.)
Costs
• Tax costs
• Shoe-leather costs
• Confusion costs
• Uncertainty costs
The cost of inflation depends on its rate and its predictability