Economics
Chapter 5
Inflation, Deflation and
the Money Market
Inflation and deflation

Inflation


A persistent increase in the general price level
Deflation

A persistent decrease in the general price level
Main features of inflation and deflation
Persistent
1.



Not once-and-for-all
E.g. Tobacco tax  Price of cigarette 
(price increases once only, not inflation)
General price level
2.

Overall increase/decrease in the prices of goods & services
Overall adjustment of the money price of goods
3.

During inflation


Value of the money falls
Purchasing power of money falls
Monetary phenomenon
4.

Too much money, but too few goods
Main features of inflation and deflation
Relationship between money and inflation

Inflation


Persistence increase in general money prices
If there is no money


No money prices
No inflation
The Quantity Theory of Money (QTM)
(貨幣數量論)
Basic concepts
1. Nominal income and real income
2. The velocity of circulation of money
3. The equation of exchange
The Quantity Theory of Money (貨幣數量論)
1. Nominal income and real income
 Real income (Y)




Total output
Quantity of production
GDP at constant price
Nominal income (PY)



Monetary value of total output
General price level (P) x Quantity (Y)
GDP at market price
The Quantity Theory of Money (貨幣數量論)
2. The velocity of circulation of money
 Denoted as “ V ”
 Average number of times a unit of money is
circulated (or changes hands) in a period to buy
national output
The Quantity Theory of Money (貨幣數量論)
Illustration
 A pays $100 for B’s product
B’s income = $100
 B pays $100 (income he gain from A) for C’s product
C’s income = $100
$100
$100
Output
Value = $100


C
B
A
Output
Value = $100
The $100 circulated for the purchases = 2 times
Velocity of circulation of money in this year = 2
The Quantity Theory of Money (貨幣數量論)
Try this
 Assume the Ms = $100
 What is the velocity of circulation of this $100?
$100
$100


$100
$100
$100
F
C
B
A
E
D
The $100 circulated for the purchases = 5 times
Velocity of circulation of money in this year = 5
The Quantity Theory of Money (貨幣數量論)
Try this
 Assume the Ms = $100
 What is the velocity of circulation of this $100?
 $100 
A
B
 $100 
 $100 
 $100 
 $100 
 $100 



The $100 circulated for the purchases = 6 times
Velocity of circulation of money in this year = 6
The $100 finally goes to Mr. A
The Quantity Theory of Money (貨幣數量論)
Try this
 In a one-man economy, assume the Ms = $100
 What is the velocity of circulation of this $100?
A
 $100 



The $100 circulated for the purchases = 0 times
Velocity of circulation of money in this year = 0
The QTM cannot be used to explain anything.
The Quantity Theory of Money (貨幣數量論)
Try this
 In a barter system, with no Ms
 What is the velocity of money?
A



B
Since there is no money supply,
Velocity of circulation of money cannot be measured
The QTM cannot be used to explain anything.
The Quantity Theory of Money (貨幣數量論)
Illustration
 A pays $100 for B’s product
B’s income = $100
 B pays $100 (income he gain from A) for C’s product
C’s income = $100
$100
$100
Output
Value = $100


C
B
A
Output
Value = $100
The $100 circulated for the purchases = 2 times
Velocity of circulation of money in this year = 2
The Quantity Theory of Money (貨幣數量論)
In another point of view
 There is only $100 cash circulated in the market
  Money supply (M) = $100
 Total market value = P x Y = $100 x 2 = $200

$200
Then, Velocity (V) =
=2
$100
[meaning that each unit of money is necessary to circulate
twice (velocity) to finance the purchase of national output]

Formula:
𝑃𝑌
V=
𝑀
The Quantity Theory of Money (貨幣數量論)
3. The equation of exchange
𝑃𝑌
𝑀

From the formula: V =

Rewrite as: MV = PY

MV = Ms x No. of times in circulation
= Total expenditure on goods & services
PY = Price x Output
= Total nominal income
Since
Total expenditure = Total nominal income


(GDP by expenditure approach)

Then, Equation of exchange :
(GDP by income approach)
MV = PY
Explanation of inflation by the QTM
1.
Long-term effects (Classical QTM)
Assumptions
 The velocity of circulation of money is stable.



Statistics show that velocity of M2 is quite stable.
V is constant.
Real nation income is constant.

Price mechanism leads to full employment
 Full employment: resources and technology are fully utilized.
  Production is maximized already.
 Y is constant.
Explanation of inflation by the QTM
Long-term effects (Classical QTM)
According to the equation
1.
MV = PY

If V and Y are constant,


When MS  5%  Price level  5%
Conclusion:
 M V =  PY
%M = % P
Explanation of inflation by the QTM
The Classical QTM in long run
 Given the equation with



M V= P Y
When



constant velocity of money
constant real output
Ms   P 
Ms   P 
In order words,


Expansionary monetary policy ( Ms  , r  )  Inflation (P )
Contractionary monetary policy ( Ms , r  )  Deflation (P )
Explanation of inflation by the QTM
1.
Short–term effects (Modern QTM)
Assumptions
 Modern economic explanation:
If Ms   Real income  (in short run)
 Expansion of firms
 Illustration
 Ms   P 
 More profit  Firm expands production (i.e. Y)
 Market is finally back to equilibrium level (in long run)

Explanation of inflation by the QTM
1.
Short–term effects (Modern QTM)
Explanation:
 Given MV = PY

where M = Money supply, V = Velocity of circulation of money,
P = Price level, Y= Real income

Velocity of money is constant
 M V =  (P Y)
In short run, Ms   PY (nominal income) 
 That is, when Ms   Both P & Y 

Explanation of inflation by the QTM
Short-term effects (Modern QTM)
According to the equation
1.
MV = PY

If V is constant,


When MS  5%  Nominal income (PY)  5%
Conclusion:
 M V =  PY
%M = % P+ % Y
Explanation of inflation by the QTM
Conclusion
1. Long-term effects (Classical QTM)

V and Y are constant
 M V =  PY

Increase in Ms  Increase in P

%  Ms = % P

Inflation rate = Growth rate of Ms

Inflation occurs because of the increase in money supply
Explanation of inflation by the QTM
For calculation
Long-term effects (Classical QTM)
 %  Ms = % P

Question:
Given that the money supply grows at a rate 5% p.a..
Base on the classical QTM, what will be the yearly
inflation rate?
 Answer:
% Ms = % P
5% = % P  % P = 5%
 Yearly inflation rate = 5%
Explanation of inflation by the QTM
Conclusion
2. Short–term effects (Modern QTM)

V is constant
 M V =  PY

Increase in Ms  Increase in nominal income (PY)
 Increase in P & Y

%  Ms = % P + % Y

Inflation rate < Growth rate of Ms

Inflation occurs partly because of the increase in money supply
Explanation of inflation by the QTM
For calculation
Short-term effects (Modern QTM)
 %  Ms = % P + % Y

Question:
Given that the money supply increase by 10% and the
real income increases by 3% in the mean time. Base on
the modern QTM, what will be the inflation rate?
 Answer:
%  Ms = % P + % Y
10% = % P + 3%  % P = 10% - 3% = 7%
 Inflation rate = 7%
Explanation of inflation by the QTM
Points to remember:
1.  Ms =  P



Increase in money supply leads to increase in price level
There is inflation, but
Not increase in inflation rate
Question (textbook p.142):
In the long run, if there is a persistent increase in money supply, the
inflation rate will rise. True or false?
Answer:
It’s incorrect. The inflation rate will rise only when there is a
persistent growth rate of the money supply.
(i.e. Inflation rate = %P = %Ms )
Explanation of inflation by the QTM
Points to remember:
1. % Ms = % P = inflation rate


Decrease in the growth rate of money supply leads to decrease
in inflation rate
Since there is still inflation, price level increases
Question (textbook p.142):
In the long run, if the growth rate of the money supply falls, the price
level will fall. True or false?
Answer:
It’s incorrect. The price level will fall only when there is negative
growth in the money supply.
(i.e. Ms = P)
(Growth rate of Ms  ≠ Ms )
Explanation of inflation by the QTM
3. Inflation is a monetary phenomenon


Classical QTM:
A persistent increase in money supply causes inflation.
Explanation (Milton Friedman)

Money is a medium of exchange (for transactions purposes)
 More money on hand, people will like to buy more goods,
i.e. demand for goods increases
 Without increase in output, price level will rise.
P ($)
P ($)
S
P0
0

Q0
S0
P2
P1
E0
P0
D0
S1
Q
(units)
E1
E0
D0
0
Q0 Q1
Conclusion
There is too much money chasing too few goods.
D1
Q
(units)
Practice Paper 1 Q.33
Which of the following statements about the classical
quantity theory of money is INCORRECT?
A. Both the velocity of circulation of money and the real
output are assumed to be constant.
B. Any change in money supply will lead to the same
proportional change in nominal output.
C. Deflation will occur when there is a continuous fall in
money supply.
D. Any change in price level will lead to the same
proportional change in money supply.
Practice Paper 2 Q.14
The following table shows the balance sheet of the banking system of an
economy:
Assets ($ million)
Liabilities ($ million)
Reserves
1 000 Deposits
4 000
Loans
3 000
Suppose the public in this economy always holds $500 million cash and the
banking system never holds excess reserves.
a. Calculate the monetary base and money supply of the economy. (2 marks)
b. Suppose the central bank lowers the minimum reserve ratio of the banking
system by 5%.
i. Explain whether the monetary base of the economy changes. (2 marks)
ii. Calculate the new money supply. Show your working. (4 marks)
c. According to the quantity theory of money, explain how the above change
in money supply affects the general price level in the long run. (4 marks)
Practice Paper 2 Q.14
The following table shows the balance sheet of the banking system of an
economy:
Assets ($ million)
Liabilities ($ million)
Reserves
1 000 Deposits
4 000
Loans
3 000
Suppose the public in this economy always holds $500 million cash and the
banking system never holds excess reserves.
a. Calculate the monetary base and money supply of the economy. (2 marks)
Monetary base = $1 000 million + $500 million = $1 500 million (1)
Money supply = $4 000 million + $500 million = $4 500 million (1)
Practice Paper 2 Q.14
b. Suppose the central bank lowers the minimum reserve ratio of the banking
system by 5%.
i. Explain whether the monetary base of the economy changes. (2 marks)
No, because (1)
the policy affects neither the amount of reserves nor the cash held by the
general public. (1)
ii. Calculate the new money supply. Show your working. (4 marks)
Before the policy change, the minimum reserve ratio =
$1 000million
= 0.25 (1)
$4 000million
The new minimum reserve ratio = 0.25 – 0.05 = 0.2 (1)
The banks will lend out the excess reserves.
1
New deposits = $1 000 million x 0.2 = $5 000 million (1)
New money supply = $500 million + $5 000 million = $5 500 million (1)
Practice Paper 2 Q.14
c. According to the quantity theory of money, explain how the above change
in money supply affects the general price level in the long run. (4 marks)
The equation of exchange:
MV = PY, where M = money stock,
V = V velocity of circulation of money,
P = general price level and
Y = real output (1)
According to the quantity theory of money, which assuming V and Y are
constant in long run, (1)
an increase in M will result in a rise in P by the same percentage. (1)
Increase in money supply = [ ($5500 - $4500) / $4500 ] x 100%
= 22.22%
So, inflation rate is 22.22% (1)
Hyperinflation
Highest monthly inflation rates in history
Country
Currency
name
Month with
highest
inflation rate
Highest
monthly
inflation rate
Equivalent
daily inflation
rate
Time required
for prices to
double
Hungary
Hungarian
pengő
July 1946
4.19 × 1016 %
207 %
15 hours
Zimbabwe
Zimbabwe
dollar
November
2008
7.96 × 1010 %
98 %
24.7 hours
Yugoslavia
Yugoslav
dinar
January 1994
3.13 × 108 %
64.6%
1.4 days
Germany
German
Papiermark
October 1923
29,500 %
20.9 %
3.7 days
Greece
Greek
drachma
October 1944
13,800 %
17.9 %
4.3 days
Taiwan
Old Taiwan
dollar
May 1949
2,178 %
11%
6.7 days
Inflation and interest rates
Interest

The price of an earlier availability of goods.
Nominal interest


Interest calculated in terms of money
E.g.
 Mr. A borrows $100 from a bank.
 He pays back $110 after a year. (Principle=$100, interest=$10)
 Nominal interest = $10

Nominal interest rate =
$10
$100
𝑥 100% = 10%
Inflation and interest rates
Real interest


Interest calculated in terms of goods (or purchasing power of money)
E.g.
 Suppose a cup costs $10.
 $100 (principle) can exchange for 10 cups.
 If the price of a cup remains unchanged (no inflation),
i.e. $10 per cup
 $110 (principle + interest) can exchange for 11 cups.
 Real interest = 1 cup

Real interest rate =
1 𝑐𝑢𝑝
10 𝑐𝑢𝑝𝑠
𝑥 100% = 10%
Inflation and interest rates
In reality


Loan agreement: in terms of nominal interest rates
However, real interest rates affects our purchasing power
Measure in nominal interest rate

In terms of money:



Borrow = $100
Interest = $10
Nominal interest rate = 10%
If price of cup remains unchanged, i.e. $10 per cup,

In terms of goods




Borrow = 10 cups ($100)
Interest = 1 cups
Real interest rate = 10%
Without inflation: Nominal interest rate = Real interest rate
Inflation and interest rates
Measure in nominal interest rate

In terms of money:



Borrow = $100
Interest = $10
Nominal interest rate = 10%
If price of cup increases, i.e. $11 per cup,

In terms of goods





With inflation,


Borrow = 10 cups ($100)
Pay back = 10 cups ($110)
Interest = 0 cups
Real interest rate = 0%
The purchasing power of money reduces by 10%
Nominal interest rate offsets the adverse effect of inflation on
purchasing power

In this case, realized real interest rate = 0%
Inflation and interest rates
Mr. A has $100
 Nominal interest rate = 10%
Yr. 2011
Price = $10/pcs
Yr. 2012
Price = $12/pcs
Buy now
10 pens
A

Buy later
9 pens
Loan out:
$100
(Nominal interest
rate=10%)
B
Repay:
$110
A
Because of inflation: Real interest rate < 10%,
Inflation and interest rates
Formula:
Realized real interest rate = Nominal interest rate – Actual inflation rate
(Note that “realized” and “actual” are used because the value are already known.)
Cases:
1. Nominal interest rate = Actual inflation rate,
Realized real interest rate = 0%
2.
Nominal interest rate > Actual inflation rate,
Realized real interest rate > 0%
3.
Nominal interest rate < Actual inflation rate,
Realized real interest rate < 0%
Inflation and interest rates
Question:
If Peter borrows money from the bank with nominal interest rate 5%p.a.
and the actual inflation rate in this year this is 3%, what is the realised
real interest rate?
Answer:
Realized real interest rate
= Nominal interest rate – Actual inflation rate
= 5% - 3%
= 2%
Inflation and interest rates
Question:
Martin borrowed $50,000 from the bank a year ago. He paid back
$54,000 to the bank when the loan was due. Given the inflation rate
was 2% in that year. Calculate the realised real interest rate?
Answer:
Nominal interest = $54,000 - $50,000 = $4000
Nominal interest rate =
$4000
$50000
𝑥 100% = 8%
Realized real interest rate = Nominal interest rate – Actual inflation rate
= 8% - 2%
= 6%
The Fisher equation *
Irving Fisher (1867-1947)
Relationship between
 nominal interest rate
 real interest rate
 the anticipated inflation rate (預期通脹率)
Fisher equation
Nominal interest rate = Real interest rate + Anticipated inflation rate



If anticipated inflation rate = 3%
To compensate lender, borrower needs to pay 3% on top of the real
interest rate to lender for the loss of purchasing power
This 3% is known as inflation premium. 通脹溢價
The Fisher equation *
From Fisher equation
Nominal interest rate = Real interest rate + Anticipated inflation rate
Real interest rate = Nominal interest rate – Anticipated inflation rate
Example
 Nominal interest rate = 10%
 Anticipated inflation rate = 4%
By using Fisher equation
 Real interest rate = 10% - 4% = 6%
Explanation
 Making a loan is “expected” to yield a real return of 6%
The Fisher equation *
Real interest rate in Fisher equation
Real interest rate = Nominal interest rate – Anticipated inflation rate

Inflation is anticipated only.
 Not accurate in reality.
 Real interest rate determined before making loan.
Realized real interest rate when loan is due
Realized real interest rate = Nominal interest rate – Actual inflation rate


Inflation actually happened.
Actual inflation rate in reality.
The Fisher equation *
Real interest rate vs. Realized real interest rate
Real interest rate = Nominal interest rate – Anticipated inflation rate
Assume nominal interest rate = 10%
If anticipated inflation rate = 3%, but actual inflation rate is 7%



Base on the anticipation, lender agrees
Real interest rate = 10% - 3% = 7%
But when the loan is due, lender gets
Realized real interest rate = 10% - 7% = 3%
Lender has loss of 4% purchasing power because of the inaccurate
anticipation of inflation.
The Fisher equation *
Question:
Suppose the real interest rate and the anticipated inflation rate are 8%
and 10% respectively.
(a) Find the nominal interest rate.
(b) Suppose the actual inflation rate is 15%. Find the realized real
interest rate.
Answer:
(a) From Fisher equation
Nominal interest rate = Real interest rate + Anticipated inflation rate
= 8% + 10% = 18%
(b) Realized real interest rate = Nominal interest rate – Actual inflation rate
= 18% - 15% = 3%
Redistributive effects* (再分配)
Unanticipated inflation (非預期通脹)

A situation that
Actual inflation rate > Anticipated inflation rate
Actual inflation rate < Anticipated inflation rate

Causes income of some people to be transferred to others.

Known as “redistributive effects”

Think about



Will there be the transfer of purchasing power?
Who will gain?
Who will lose?
Redistributive effects*
Illustration

Suppose there’s a loan agreement between two people.
Mr. A (borrower) borrows $10,000 from Mr. B (lender)

Mr. B:


Wants to get 5% (real) interest from $10,000 loan
 Anticipated inflation rate = 3%
From Fisher equation:
 Nominal interest rate = 5% + 3% = 8%
 i.e. Mr. B contracts with Mr. A $10,000 loan in return 8% nominal interest rate
Case 1
 One year later when the loan is due


Actual inflation rate is 6%
Realized real interest rate = nominal interest rate – actual inflation rate
= 8% - 6% = 2%
Redistributive effects*
Case 1: Inflation rate > Expected
[i.e. Actual inflation rate (6%) > Anticipated inflation rate (3%)]

To Mr. B (lender)




To Mr. A (borrower)




Expected to get 5% real interest
Finally got 2% real interest
Lose
Expected to pay 5% real interest
Finally paid 2% real interest
Gain
Conclusion
Because of unanticipated inflation
 Real income transfers from lender to borrower
 Redistributive effects can be found
Redistributive effects*
Illustration

Suppose there’s a loan agreement between two people.
Mr. A (borrower) borrows $10,000 from Mr. B (lender)

Mr. B:


Wants to get 5% (real) interest from $10,000 loan
 Anticipated inflation rate = 3%
From Fisher equation:
 Nominal interest rate = 5% + 3% = 8%
 i.e. Mr. B contracts with Mr. A $10,000 loan in return 8% nominal interest rate
Case 2
 One year later when the loan is due


Actual inflation rate is 1%
Realized real interest rate = nominal interest rate – actual inflation rate
= 8% - 1% = 7%
Redistributive effects*
Case 2: Inflation rate < Expected
[i.e. Actual inflation rate (1%) < Anticipated inflation rate (3%)]

To Mr. B (lender)




To Mr. A (borrower)




Expected to get 5% real interest
Finally got 7% real interest
Gain
Expected to pay 5% real interest
Finally paid 7% real interest
Lose
Conclusion
Because of unanticipated inflation
 Real income transfers from borrower to lender
 Redistributive effects can be found
Redistributive effects*
Illustration

Suppose there’s a loan agreement between two people.
Mr. A (borrower) borrows $10,000 from Mr. B (lender)

Mr. B:


Wants to get 5% (real) interest from $10,000 loan
 Anticipated inflation rate = 3%
From Fisher equation:
 Nominal interest rate = 5% + 3% = 8%
 i.e. Mr. B contracts with Mr. A $10,000 loan in return 8% nominal interest rate
Case 3
 One year later when the loan is due


Actual inflation rate is 3%
Realized real interest rate = nominal interest rate – actual inflation rate
= 8% - 3% = 5%
Redistributive effects*
Case 3: Inflation rate = Expected
[i.e. Actual inflation rate (3%) = Anticipated inflation rate (3%)]

To Mr. B (lender)




To Mr. A (borrower)




Expected to get 5% real interest
Finally got 5% real interest
No gains or loses
Expected to pay 5% real interest
Finally paid 5% real interest
No gains or loses
Conclusion
Because of accurate anticipated inflation
 No real income transfers between borrower and lender
 No redistributive effects
Redistributive effects*
Case study (p.149)



Mr. Wong gives a 1-year loan to his friend
Market interest rate = 9% per annum
Anticipated inflation rate = 3%
1.
What is the real interest rate and the inflation premium?
Real interest rate = 9% - 3% = 6%
Inflation premium = anticipated inflation rate = 3%
2.
Suppose the actual inflation rate = 1%
Inflation premium high enough to offset the loss of purchasing power?
( Yes / No )
What is the realized real interest rate?
Realized real interest rate
= Nominal interest rate – Actual inflation rate
= 9% - 1% = 8%, which is higher than anticipated.
a.
b.
Redistributive effects*
Conclusion: Lenders vs. Borrowers

If actual inflation rate > anticipated inflation rate



If actual inflation rate < anticipated inflation rate



Lenders lose
Borrowers gain
Lenders gain
Borrowers lose
If actual inflation rate = anticipated inflation rate

No one gains or loses
Redistributive effects*
II.
Employers vs. Employees
Suppose the employers pay fixed nominal wage to employees.
Case 1: Inflation rate > Anticipated inflation rate

To employers





Pay fixed nominal wage
Higher inflation  Lower purchasing power of the same unit of money
i.e. Pay lower real wage
Gain
To employees




Get fixed nominal wage
Higher inflation  Lower purchasing power of the same unit of money
i.e. Get lower real wage
Lose
Redistributive effects*
II.
Employers vs. Employees
Suppose the employers pay fixed nominal wage to employees.
Case 2: Inflation rate < Anticipated inflation rate

To employers





Pay fixed nominal wage
Lower inflation  Higher purchasing power of the same unit of money
i.e. Pay higher real wage
Loses
To employees




Get fixed nominal wage
Lower inflation  Higher purchasing power of the same unit of money
i.e. Get higher real wage
Gain
Redistributive effects*
Conclusion: Employers vs. Employees

If actual inflation rate > anticipated inflation rate



If actual inflation rate < anticipated inflation rate



Employers gain
Employees lose
Employers lose
Employees gain
If actual inflation rate = anticipated inflation rate

No one gains or loses
Redistributive effects*
III.


Government vs. Taxpayers
Inflation usually raises nominal wage.
In HK (progressive tax): Higher wage  Higher salary tax
Case: Inflation rate > Expected

To taxpayers





Higher nominal wage  Higher tax rate  Higher real tax payment
Higher inflation offsets the purchasing power of income
i.e. No increase in real wage
Lose
To government


Higher nominal wage  Higher tax rate  Higher real tax revenue
Gains
Redistributive effects*
Conclusion: Government vs. Taxpayers

If actual inflation rate > anticipated inflation rate


Government gains
Taxpayers lose

People argue that during the time of high inflation, the
government take away taxpayers’ real income (i.e.
purchasing power of money they earn).

It’s somehow like a “robbery” from the citizen.

Income disparity is more serious, esp. to the middle class.
Redistributive effects*
III.


Government vs. The root class
Government pays fixed amount in CSSA Scheme.
(Comprehensive Social Security Assistance)
Real expenditure is lowered.
Case: Inflation rate > Expected

To CSSA recipients




Fixed nominal amount in CSSA Scheme
Higher inflation  Lower real amount received
Lose
To government



Fixed expenditure
Higher inflation  Lower real expenditure
Gains
Redistributive effects*
Conclusion: Government vs. The root class

If actual inflation rate > anticipated inflation rate


Government gains
Poor people lose

People argue that during the time of high inflation, the
government spends less to help the poor.

Income disparity is more serious, esp. to the root class.
Redistributive effects*
IV.


Transaction with deferred payment
Agreement to pay later
e.g. buying a TV set with 24-month installments
Case: Inflation rate > Anticipated inflation rate

To buyers




Fixed nominal amount of payment
Higher inflation  Lower real payment
Gain
To sellers



Fixed nominal amount to receive
Higher inflation  Lower real receipt
Lose
Redistributive effects*
Others:
If actual inflation rate > anticipated inflation rate
 Depositors vs. Banks



Depositors lose
Banks gain
Insurance policy holders vs. Insurance company

Policy holder (with fixed amount of claim) lose

If a person dies, get $1million (fixed nominal claim)
 However, $1 million means less real amount after inflation, esp,
after many years.

Insurance company gain
Full anticipated inflation
If the inflation rate is fully anticipated



Actual inflation rate = Anticipated inflation rate
Realized real interest rate = Anticipated real interest rate
Remember the 2 equations
Realized real interest rate = Nominal interest rate + Actual inflation rate
Real interest rate = Nominal interest rate + Anticipated inflation rate


So, all wages, gov’t expenditures, etc. will be adjusted according
to the accurately forecast inflation rate
No redistributive effects
Indexing and inflationary expectation
Indexing

Adjustment of future income or payment according to
the price index

Example
 Real interest rate for a one-year loan = 5%
Case 1
 When the loan is due, and the actual inflation rate is 3%
 Borrowers need to pay a nominal rate = 5% +3% = 8%
Case 2
 When the loan is due, and the actual inflation rate is 10%
 Borrowers need to pay a nominal rate = 5% +10% = 15%

Floating nominal interest rate
 Can offset the income distributive effects under inflation or deflation
Self-study: Redistributive effects
1.
Think about different situations
1.
2.
3.
2.
Think about deflation
1.
2.
3.
3.
Actual inflation rate > Anticipated inflation rate
Actual inflation rate < Anticipated inflation rate
Actual inflation rate = Anticipated inflation rate
Actual deflation rate > Anticipated deflation rate
Actual deflation rate < Anticipated deflation rate
Actual deflation rate = Anticipated deflation rate
Ask yourself, who will gain and who will lose in
the above situations.
Money demand (Md)
Assets people have:

Money (cash & deposits)
 Shares
 Bonds
 Properties (house, apartment, flat)
What is money demand?



Mr. A’s total asset: $1,000,000
[Money(40%) + Shares(40%) + Bonds(20%)]
Demand of money
= The quantity of money (40% of $1,000,000) he holds
In other words, money demand means
how much cash and deposit people want to hold.
Motive for holding money
Why do people need to hold money?
1. Transaction demand for money


People need money to buy things
Daily transaction
2. Asset demand for money


Keep the value of asset
As a store of value
Motive for holding money
1. Transaction demand for money
 As a medium of exchange

Daily transaction at

Fast food shop
 newspaper stand
 taxi

Hold money for later use

Enable consumption any time
Motive for holding money
Transaction demand for money and real income
 If real income 

More willing to buy things
  Consumption 
 Need more money for transaction
  Transaction demand for money 

If real income 




Better to save money
 Consumption 
No need to have money for transaction
 Transaction demand for money 
Motive for holding money
Transaction demand for money

The demand for money as a medium of exchange.

It is positively related to real income

Higher real income
 Higher money demand for transaction
Motive for holding money
2. Asset demand for money
 As a store of value

Holding money (cash & demand deposits)




No interest returns
Lower risk
Higher liquidity
Holding bonds / shares

Interest earning
 Risk of value change
 Lower liquidity
Motive for holding money
2. Asset demand for money
Suppose 2 types of assets only
 Holding money means giving up interest earning


Forgone nominal interest return from bonds
Nominal interest rate 
 Cost of holding money 
 Demand of holding money 
 Asset demand for money 

Nominal interest rate 
 Cost of holding money 
 Demand of holding money 
 Asset demand for money 
Motive for holding money
2. Asset demand for money

Nominal interest rate   Asset demand for money 

Nominal interest rate   Asset demand for money 
The demand for money as a store of value:



It is negatively related to the nominal interest rate.
When nominal interest rate is high
 quantity demanded of money is low;
when nominal interest rate is low
 quantity demanded of money is high.
The effects of price level on money demand

Holding money is usually for transaction
 Amount to hold depends of the real value of money

i.e. the value of goods (purchasing power of money)

Nominal money balance
= The face value of total amount of money

Real money balance
= The real value in terms of purchasing power
The effects of price level on money demand
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑚𝑜𝑛𝑒𝑦 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙

Real money balance =

If Mr. A wants to buy 10 boxes of chocolate :
Real demand for money
(10 boxes of chocolate)
Price level
Nominal demand for money
10
$10
$100
10
$20
$200
 Price   Nominal demand for money 
 Same extent
 Ceteris paribus

Other factors affecting the money demand

Payment technology



Octopus card / EPS / Credit card / Paypal
 Cash transaction 
 Cost to convert asset to cash 
e.g. spending time to withdraw cash at the ATM
 Demand of money 
Risk associated with other assets


Risk of losing value of bonds, shares or real estate
 Demand of money 
Other factors affecting the money demand

Inflationary expectation
Fisher equation:
Nominal interest rate = Real interest rate + Anticipated inflation rate

If anticipated inflation rate 
 Nominal interest rate 
 Cost of holding cash 
 Demand of money 

Higher the anticipated inflation rate Lower the money demand



Interest-rate determination in the
money market
1. Money demand curve
 Higher the interest rate Lower the money demand
 Downward sloping
Interest rate (%)
r1
r2
Md
0
Q1
Q2
Quantity of money
Interest-rate determination in the
money market



Interest-rate related
If nominal interest rate drops from 3% to 2%
 Quantity demanded of money increases from $100 to $120
Movement along the money demand curve
Interest rate (%)
3
2
Md
0
100
120
Quantity of money
Interest-rate determination in the
money market



Income related
If real income , Md shifts rightward from Md1 from Md2
If real income , Md shifts leftward from Md1 from Md3
Interest rate (%)
M d3
0
M d1
M d2
Quantity of money
Interest-rate determination in the
money market
2. Money supply curve
 Controlled by the government (monetary policy)  Vertical Ms curve


Expansionary monetary policy ( Ms  )
 Ms curve shifts rightward from Ms1 from Ms2
Contractionary monetary policy ( Ms )
 Ms curve shifts leftward from Ms1 from Ms3
Interest rate (%)
Interest rate (%)
Ms1
Ms1
Ms3
Ms
0
Quantity of
money
0
Ms2
Ms
Quantity of
money
Interest-rate determination in the
money market
3. Equilibrium interest rate


Interest rate is at the level that money demand equals money supply.
Md = Ms
Interest rate (%)
Ms
Equilibrium interest rate
r
Md
0
Quantity of
money
Interest-rate determination in the
money market
Interest rate (%)
Excess demand for money
 Interest rate is lower than
the equilibrium interest rate
 Md > Ms
 Money shortage
Ms
r
Excess
demand
Md
Quantity of
money
0
Interest rate (%)
Excess supply for money
 Interest rate is higher than
the equilibrium interest rate
 Ms > Md
 Surplus of money
Excess
supply
Ms
r
Md
0
Quantity of
money
Changes in the interest rate
Change in money demand
 Increase in the money demand



Reason: increase in real income  more transaction
Money demand curve shifts rightward (from Md1 to Md2)
Interest rate  (from r1 to r2)
Interest rate (%)
Ms
r2
r1
Md1
0
Md2
Quantity of
money
Changes in the interest rate
Change in money demand
 Decrease in the money demand



Reason: decrease in real income  less transaction
Money demand curve shifts leftward (from Md1 to Md2)
Interest rate  (from r1 to r2)
Interest rate (%)
Ms
r1
r2
Md2
0
Md1
Quantity of
money
Changes in the interest rate
Question: (p.162)
Suppose the GDP for Country A rises. With the aid of a diagram,
explain how this will affect the interest rate of Country A.
Answer:
 As GDP is the measure of the national income, rise in GDP
means increase in income, which will lead to increase in money
Interest rate (%)
demand.
Ms
 The money demand curve
 shifts rightward from Md1
to Md2.
r2
 Interest rate increases
from r1 to r2.
r1
Md1
0
Md2
Quantity of
money
Changes in the interest rate
Change in money demand and money supply at the same time
 Increase in the money supply



Reason: Expansionary monetary policy
Money supply curve shifts rightward (from Ms1 to Ms2)
Interest rate  (from r1 to r2)
Interest rate (%)
Ms 1
Ms2
r1
r2
Md
0
Quantity of
money
Changes in the interest rate
Change in money demand and money supply at the same time
 Decrease in the money supply



Reason: Contractionary monetary policy
Money supply curve shifts leftward (from Ms1 to Ms2)
Interest rate  (from r1 to r2)
Interest rate (%)
Ms 2
Ms 1
r2
r1
Md
0
Quantity of
money
Changes in the interest rate
Change in money demand and money supply at the same time
 Money demand   Interest rate 
 Money supply   Interest rate 
Case 1: Md  = Ms   Interest rate remains unchanged
Interest rate (%)
Ms 1
Ms 2
r1
Md1
0
Md2
Quantity of
money
Changes in the interest rate
Change in money demand and money supply at the same time
 Money demand   Interest rate 
 Money supply   Interest rate 
Case 2: Md  > Ms   Interest rate 
Interest rate (%)
Ms 1 Ms 2
r2
r1
Md2
Md1
0
Quantity of
money
Changes in the interest rate
Change in money demand and money supply at the same time
 Money demand   Interest rate 
 Money supply   Interest rate 
Case 3: Md  < Ms   Interest rate 
Interest rate (%)
Ms 1
Ms 2
r1
r2
Md1
0
Md2
Quantity of
money
Changes in the interest rate
Change in money demand and money supply at the same time
 Money demand   Interest rate 
 Money supply   Interest rate 
Case 1: Md  = Ms   Interest rate remains unchanged
Interest rate (%)
Ms 2
Ms 1
r1
Md2
0
Md1
Quantity of
money
Changes in the interest rate
Change in money demand and money supply at the same time
 Money demand   Interest rate 
 Money supply   Interest rate 
Case 2: Md  > Ms   Interest rate 
Interest rate (%)
Ms 2 Ms 1
r1
r2
Md2
0
Md1
Quantity of
money
Changes in the interest rate
Change in money demand and money supply at the same time
 Money demand   Interest rate 
 Money supply   Interest rate 
Case 3: Md  < Ms   Interest rate 
Interest rate (%)
Ms 2
Ms 1
r2
r1
Md2
0
Md1
Quantity of
money