Money, Interest Rate and Inflation

1
Money, Interest Rate and Inflation

• Chapter 13

2
Money and the Interest Rate

• Demand for money
• There are benefit and cost of holding money.
• The benefit of holding money is the convenience
  of making payments and do transactions.
• The opportunity cost of holding money is the
  nominal interest rate foregone on an alternative
  asset (e.g. bonds and CDs)
• Given constant benefit of holding money, the
  higher the nominal interest rate, the smaller is
  the quantity of money demanded.
• Downward-sloping demand curve for money

3
Money and the Interest Rate (Continued)

• Shifts in the demand for money curve
• Changes in the price level
• Changes in real GDP
• Changes in financial technology
• Supply of money
• Fixed (vertical curve) at a given point of time
• The supply of and demand for money will determine
  the equilibrium nominal interest rate.

4
Money and the Interest Rate (Continued)

• Nominal interest rate
• Nominal interest rate real interest rate
  inflation rate
• The interest rate and bond price move in opposite
  directions
• The Fed can affect the nominal interest rate
• Discount rate ?federal funds rate ? prime rate
• Change in money supply ? change in the nominal
  interest rate

5
Money and Inflation

• Equation of Exchange
• M V P Y (or Q)
• Velocity of money the average number of times
  money spent on purchase of final products
• Quantity Theory of Money
• Velocity (V) and aggregate output (Y or Q) are
  unaffected by a change in money supply
• A change in money supply (M) will result in a
  proportional change in the price level (P)

6
Money and InflationContinued

• Short-run vs. long-run
• In the short-run, the money supply increase
  causes a fall in the nominal interest rate.
• However, in the longrun, the money supply
  increase also results in the higher price level,
  causing increase in the demand for money.
• So, the nominal interest rate returns to its
  long-run equilibrium level.

7
Monetarism

• A school of economic thought founded by Milton
  Friedman
• Modern version of the quantity theory
• Rule-based money supply rather than discretionary
  monetary policy
• Increase money supply at a steady rate equal to
  or slightly larger than the long run growth in
  output
• At 3 or slightly higher

8
Effects and Costs of Inflation

• Effects
• Inflation is a tax transfer of resources from
  the private sector to government
• Inefficient use of time and resources
• Confusion and uncertainty discourage savings and
  investment ? decrease in output and slowdown in
  economic growth
• The cost of inflation depends on the degree of
  inflation
• Mild inflation (3 or less) small
• Hyper-inflation great