Bade Ppt Ch28lect

8/3/2019 Bade Ppt Ch28lect

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Money, Interest, andInflation

CHAPTER

28


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C H A P T E R C H E C K L I S T

When you have completed your study of thischapter, you will be able to

1 Explain what determines the demand for money andhow the demand for money and the supply of moneydetermine the nominal interest rate.

2 Explain how in the long run, the quantity of money

determines the price level and money growth bringsinflation.

3 Identify the costs of inflation and the benefits of a stablevalue of money.


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The Real Economy

Realfactors that are independent of the

price level determine potential GDP and thenatural unemployment rate.

Investment demand and saving supply

determine the amount of investment, the realinterest rate and, along with populationgrowth, human capital growth, andtechnological change, determine the growth

rate of real GDP.

WHERE WE ARE AND WHERE WERE HEADING


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The Money Economy

Moneythe means of paymentconsists of

currency and bank deposits.

Banks create money and the Fed influencesthe quantity of money through its open

market operations, which determines themonetary base and the federal funds rate.

Here we explore the effects of money on theeconomy.



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Real and Money Interactions and Policy

The effects of money can be best

understood in three steps: The effects of the Feds actions on the short-term

nominal interest rate

The long-run effects of the Feds actions on the

price level and the inflation rate The details between the short-run and long-run

effects



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28.1 MONEY AND THE INTEREST RATE

The Demand for Money

Quantity of money demanded is the amount of

money that households and firms choose tohold.

Benefit of Holding Money

The benefit of holding money is the ability tomake payments.

The more money you hold, the easier it is for

you to make payments.


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The marginal benefit of holding moneydecreases as the quantity of money heldincreases.

Opportunity Cost of Holding Money

The opportunity cost of holding money isthe interest forgone on an alternative asset.

Opportunity Cost: NominalInterest is a RealCost

The opportunity cost of holding money isthe nominalinterest because it is the sum of


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The Demand for Money Schedule and Curve

The demand for money is the relationship

between the quantity of money demandedand the nominal interest rate, when all otherinfluences on the amount of money thatpeople want to hold remain the same.

Figure 28.1 on the next slide illustrate thedemand for money.


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The lower the nominalinterest ratethe

opportunity cost ofholding moneythegreater is the quantityof real moneydemanded.


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1. Other thingsremaining the same,

an increase in thenominal interest ratedecreases thequantity of realmoney demanded.

2.A decrease in thenominal interest rateincreases the quantityof real money

demanded.


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Changes in the Demand for Money

A change in the nominal interest rate brings

a change in the quantity of moneydemanded.

A change in any other influence on money

holdings changes the demand for money.The three main influences are The price level

Real GDP

Financial technology


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The Price Level

Anxpercent rise in the price level brings an

xpercent increase in the quantity of moneythat people plan to hold because the numberof dollars we need to make payments isproportional to the price level.

Real GDP

The demand for money increases as realGDP increases because expenditures andincomes increase when real GDP increases.


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Financial Technology

Daily interest on checking deposits,

automatic transfers between checking andsavings accounts, automatic tellermachines, debit cards, and smart cards haveincreased the marginal benefit of money and

increased the demand for money.

Credit cards have made it easier to buygoods and services on credit and have

decreased the demand for money.


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The Supply of Money

The supply of money is the relationship

between the quantity of money supplied and

the nominal interest rate.

The quantity of money supplied isdetermined by the actions of the banking

system and the Fed.

On any given day, the quantity of money is


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The Nominal Interest Rate

The nominal interest rate adjusts to make

the quantity of money demanded equal the

quantity of money supplied.

On a given day, the price level, real GDP,and state of financial technology is fixed, so

the demand for money is given.


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The nominal interest rate is the only

influence on the quantity of money

demanded that is free to fluctuate to achieve

money market equilibrium.

Figure 28.2 on the next slide illustrates

money market equilibrium and the

adjustment toward equilibrium.


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1. If the interest rate is 6 percent a year,the quantity of money held exceeds

the quantity demanded. People buybonds, the price of a bond rises, andthe interest rate falls.

A decrease in the nominal interestrate increases the quantity of realmoney demanded.


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2. If the interest rate is 4 percent a year,the quantity of money held is less thanthe quantity demanded. People sell

bonds, the price of a bond falls, andthe interest rate rises.

A rise in the nominal interest ratedecreases the quantity of real money

demanded.3. If the interest rate is 5 percent a

year, the quantity of money heldequals the quantity demanded and

the money market is in equilibrium.


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The interest Rate and Bond Price Move in

Opposite Directions

When the government issues a bond, it

specifies the dollar amount of interest that it

will pay each year.

The interest rate on the bond is the dollar

amount received divided by the price of the

bond.


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Interest Rate Adjustment

When the interest rate is above its equilibrium level,

the quantity of money supplied exceeds the quantityof money demanded.

People are holding too much money, so they try toget rid of money by buying other financial assets.

The demand for financial assets increases, theprices of these assets rise, and the interest ratefalls.


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Conversely,

When the interest rate is below its equilibrium level,

the quantity of money demanded exceeds thequantity of money supplied.

People are holding too little money, so they try toget more money by selling other financial assets.

The demand for financial assets decreases, theprices of these assets fall, and the interest raterises.


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Changing the Interest Rate

To change the interest rate, the Fed changes

the quantity of money.If the Fed increases the quantity of money,the interest rate falls.

If the Fed decreases the quantity of money,the interest rate rises.

Figure 28.3 on the next slide illustrates these

changes.


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1. If the Fed increases thequantity of money and thesupply of money curve shifts

to MS1, the interest rate fallsto 4 percent a year.

2.If the Fed decreases the

quantity of money and thesupply of money curve shiftsto MS2, the interest rate rises

to 6 percent a year.


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28.2 MONEY, THE PRICE LEVEL, AND INFLATION

The Money Market in the Long Run

The long run refers to the economy at full

employment or when we smooth out theeffects of the business cycle.

In the short run, the interest rate adjusts to

make the quantity of money demandedequal the quantity of money supplied.

In the long run, the price level does theadjusting.


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Potential GDP and Financial Technology

Potential GDP and financial technology,

which influence the demand for money, aredetermined by real factors and areindependent of the price level.

The Nominal Interest Rate in the Long Run

The nominal interest rate equals the realinterest rate plus the expected inflation rate.

The real interest rate is independent of theprice level in the long run. The expected


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Money Market Equilibrium in the Long Run

All the influences on money holding except

the price level are determined by real forcesin the long run and are given.

In the long run, money market equilibrium

determines the price level.Figure 28.4 on the next slides illustrates thelong-run equilibrium.


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1. The demand for moneydepends on the price level.

2.The equilibrium nominalinterest rate also depends onthe price level.



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3. The long-run equilibrium realinterest rate.

4.Plusthe inflation rate

determines . . .

5. Thelong-run equilibriumnominal interest rate.

6. The price level adjusts to100 to achieve moneymarket equilibrium at thelong-run equilibrium interest

rate.



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A Change in the Quantity of Money

If the Fed increases the quantity of money

from $1 trillion to $1.02 trilliona 2 percentincreasethe nominal interest rate falls.

But eventually, the nominal interest rate

returns to its long-run equilibrium level andthe price level rises by 2 percent.

Figure 28.5 on the next slide illustrates thisoutcome.


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1.The quantity of moneyincreases by 2 percentfrom $1 trillion to $1.02

trillion and the supply ofmoney curve shifts fromMS0 to MS1.

2.In the short run, the

interest rate falls to 4percent a year.



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3. In the long run, the pricelevel rises by 2 percent

from 100 to 102, thedemand for money curveshifts from MD0 to MD1,

and the nominal interest

rate returns to its long-runequilibrium level.



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A key proposition about the quantity ofmoney and the price level is that

In the long run and other things remainingthe same, a given percentage change in thequantity of money brings an equalpercentage change in the price level.


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The Price Level in a Baby-Sitting Club

A baby sitting club uses token to pay for

neighbors baby sitting services. One sitcosts one token.

The organizers double the number of tokensby giving a token to each member for eachtoken currently held.

Equilibrium in this local baby-sitting marketis restored when the price of sit doubles to

two tokens.


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The Quantity Theory of Money

Quantity theory of money is the proposition

that when real GDP equals potential GDP, anincrease in the quantity of money brings anequal percentage increase in the price level(other things remaining the same).


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The Velocity of Circulation and Equation ofExchange

Velocity of circulation is the number of timesin a year that the average dollar of moneygets used to buy final goods and services.

Equation of exchange is an equation thatstates that the quantity of money multipliedby the velocity of circulation equals theprice level multiplied by real GDP.


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Define: The velocity of circulation = V

The quantity of money = M

The price level = P

Real GDP = Y

Then the equation of exchange is

M V= P Y


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The Quantity Theory Prediction

The equation of exchange, M V= P Y,

implies thatP= M V Y.

On the left is the price level and on the right

are all the things that influence the pricelevel.

These influences are the quantity of money,the velocity of circulation, and real GDP.


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The velocity of circulation is relatively stableand does not change when the quantity ofmoney changes.

In the long run, real GDP equals potentialGDP, which is independent of the quantity ofmoney.

So, in the long run, the price level isproportional to the quantity of money.


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Inflation and the Quantity Theory of Money

The equation of exchange tells us therelationship between the price level, thequantity of money, the velocity of circulation,and real GDP.

This equation implies a relationship between

the rates of change of these variables, whichis

Money growth + Velocity growth =Inflation rate + Real GDP growth


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The velocity of circulation grows at 1 percent ayear and real GDP grows at 3 percent a year.

If the quantity ofmoney grows at 2percent a year,

the inflation rate

is zero.


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If the quantity ofmoney grows at4 percent a year,

the inflation rate is

2 percent a year.


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If the quantity ofmoney grows at10 percent a year,

the inflation rate is8 percent a year.


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Changes in the Inflation Rate

Because, in the long run, both velocity

growth and real GDP growth areindependent of the growth rate of money:

A change in the money growth rate bringsan equal change in the inflation rate.


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Hyperinflation

If the quantity of money grows rapidly, the

inflation rate will be very high.An inflation rate that exceeds 50 percent amonth is called hyperinflation.

Highest inflation rates today are inZimbabwe, which exceeds 100 percent ayear.


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28.3 THE COST OF INFLATION

Inflation is costly for four reasons:

Tax costs

Shoe-leather costs

Confusion costs

Uncertainty costs


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Tax Costs

Government gets revenue from inflation.

Inflation Is a Tax

You have $100 and you could buy 10CDs($10 each) today or hold the $100 as money.

If the inflation rate is 5 percent a year, at theend of the year the 10 CDs will cost you$105. A tax of $5 on holding $100 of money.


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Inflation, Saving, and Investment

The core of the problem is that inflation increasesthe nominal interest rate, and because incometaxes are paid on nominal interest income, the trueincome tax rate rises with inflation.


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The higher the inflation rate, the higher isthe true income tax rate on income fromcapital.

And the higher the tax rate, the higher is theinterest rate paid by borrowers and thelower is the after-tax interest rate received

by lenders.


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Shoe-Leather Costs

So-called shoe-leather costs arise from an

increase in the velocity of circulation ofmoney and an increase in the amount ofrunning around that people do to try toavoid incurring losses from the falling value

of money.


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When money loses value at a rapidanticipated rate, it does not function well asa store of value and people try to avoid

holding it.

They spend their incomes as soon as theyreceive them, and firms pay out incomes

wages and dividendsas soon as theyreceive revenue from their sales.

The velocity of circulation increases.


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Confusion Costs

Money is our measuring rod of value.

Borrowers and lenders, workers andemployers, all make agreements in terms ofmoney.

Inflation makes the value of money change,so it changes the units on our measuringrod.


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Uncertainty Costs

A high inflation rate is brings increased

uncertainty about the long-term inflationrate.

Increased uncertainty also misallocatesresources. Instead of concentrating on theactivities at which they have a comparativeadvantage, people find it more profitable tosearch for ways of avoiding the losses that

inflation inflicts.


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How Big Is the Cost of Inflation?

The cost of inflation depends on its rate and

its predictability.The higher the inflation rate, the greater isits cost.

And the more unpredictable the inflationrate, the greater is its cost.

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