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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.
WHERE WE ARE AND WHERE WERE HEADING
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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
WHERE WE ARE AND WHERE WERE HEADING
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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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
The lower the nominalinterest ratethe
opportunity cost ofholding moneythegreater is the quantityof real moneydemanded.
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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.1 MONEY AND THE INTEREST RATE
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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.
28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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.
28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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.
28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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.
28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
The velocity of circulation grows at 1 percent ayear and real GDP grows at 3 percent a year.
If the quantity ofmoney grows at4 percent a year,
the inflation rate is
2 percent a year.
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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
The velocity of circulation grows at 1 percent ayear and real GDP grows at 3 percent a year.
If the quantity ofmoney grows at10 percent a year,
the inflation rate is8 percent a year.
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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.2 MONEY, THE PRICE LEVEL, AND INFLATION
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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28.3 THE COST OF INFLATION
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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28.3 THE COST OF INFLATION
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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28.3 THE COST OF INFLATION
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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28.3 THE COST OF INFLATION
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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28.3 THE COST OF INFLATION
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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28.3 THE COST OF INFLATION
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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28.3 THE COST OF INFLATION
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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28.3 THE COST OF INFLATION
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.