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MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate

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Macroeconomics ECO 403
VU
LESSON 12
MONEY AND INFLATION (Continued...)
The Fisher Effect
�
The Fisher equation:
i=r+�
­  S = I determines r.
­  Hence, an increase in �
causes an equal increase in i.
­  This one-for-one relationship
is called the Fisher effect.
Exercise:
Suppose V is constant, M is growing 5% per year, Y is growing 2% per year, and r = 4.
�  Solve for i (the nominal interest rate).
�  If SBP increases the money growth rate by 2 percentage points per year, find Δi .
�  If the growth rate of Y falls to 1% per year
�  What will happen to �?
�  What must SBP do if it wishes to
keep � constant?
Answers:
First, find � = 5 - 2 = 3.
Then, find i = r + � = 4 + 3 = 7.
�  Δi = 2, same as the increase in the money growth rate.
�  If SBP does nothing, Δ� = 1.
To prevent inflation from rising, SBP must reduce the money growth rate by 1
percentage point per year.
Two real interest rates
�
� = actual inflation rate
(not known until after it has occurred)
�
�e = expected inflation rate
�
i ­ �e = ex ante real interest rate:
what people expect at the time they buy a bond or take out a loan
�
i ­ � = ex post real interest rate:
what people actually end up earning on their bond or paying on their loan
Money demand and the nominal interest rate
�
The Quantity Theory of Money assumes that the demand for real money balances depends
only on real income Y.
�
We now consider another determinant of money demand: the nominal interest rate.
�
The nominal interest rate i is the opportunity cost of holding money (instead of bonds or
other interest-earning assets).
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Macroeconomics ECO 403
VU
�
Hence, ↑i ⇒ ↓ in money demand.
Linkages Among Money, Prices and Interest rate
Money
Supply
Nominal
Price
Inflation
Interest
Level
Rate
Rate
Money
Demand
The money demand function
(M P ) = L (i , Y )
d
(M/P) d = real money demand, depends
�  negatively on i
i is the opportunity cost of holding money
�  positively on Y
higher Y ⇒ more spending so, need more money
(L is used for the money demand function because money is the most liquid asset.)
(M P )d = L (i ,Y )
= L (r + �  e , Y )
When people are deciding whether to hold money or bonds, they don't know what inflation will
turn out to be.
Hence, the nominal interest rate relevant for money demand is r + �e.
M
Equilibrium
= L (r + �  e ,Y )
P
Supply of Real money balances
Real money demand
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Macroeconomics ECO 403
VU
What determines what
Variable
how determined (in the long run)
M
exogenous (SBP)
r
adjusts to make S = I
Y
Y = F (K , L )
M
P
adjusts to make
= L (i ,Y )
P
How P responds to ΔM
�
For given values of r, Y, and �e,
a change in M causes P to change by the same percentage --- just like in the Quantity
Theory of Money.
What about expected inflation?
�
Over the long run, people don't consistently over- or under-forecast inflation, so �e = � on
average.
�
In the short run, �e may change when people get new information.
EX: Suppose SBP announces it will increase M next year. People will expect next
year's P to be higher, so �e rises.
�
This will affect P now, even though M hasn't changed yet.
How P responds to Δ�e
M
= L (r + �  e ,Y )
P
�
For given values of r, Y, and M,
↑ �  e  ⇒ ↑ i (the Fisher effect)
⇒ ↓ (M P )
d
⇒ ↑ P to make (M P ) fall
to re-establish eq'm
The social costs of inflation
...fall into two categories:
1. Costs when inflation is expected
2. Additional costs when inflation is
different than people had expected.
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand