MONEY, INFLATION, ANDINTEREST RATES IN THE MARKET-CLEARING MODEL

This chapter uses the market-clearing model to study inflation and nominal
interest rates. For the main analysis we return to the setting from Chapter
5 that does not deal explicitly with a labor market or firms. As we saw in
Chapter 6, this simplification will be satisfactory for most purposes. The
basic approach will be to specify a given time path of the money stock, M,.
Then we figure out what time paths of the price level. Ptand, hence, of
the inflation rate, r,and of the nominal and real interest rates, R, and
F, will satisfy the conditions for general market clearing.
We shall focus on the consequences of different rates of anticipated
inflation and monetary growth. Even when the inflation rate, Yt, varies
over time, we assume that people forecast these changes accurately. Put
another way, people have perfect foresight about future price levels, so
that there is always equality between the actual and expected inflation
rates, r = 4. Accordingly, if peopLe know the nominal interest rate, Rt,
then there is also equality between actual and expected real interest
rates, r1 = r7.
The analysis is limited because it does not address unanticipated inflation
and monetary growth. (We shall explore these matters later.) But it is
useful to study anticipated inflation as a separate topic. In particular,
the changes in anticipated inflation explain the principal longer-term
movements in U.S. nominal interest rates since World War II.
INCORPORATION OF INFLATION AND MONETARY

GROWTH INTO THE MODEL

We want to incorporate into the model the new elements that were discussed
in Chapter 7. These new features include inflation and the distinction
between real and nominal interest rates. To analyze the link between
monetary growth and inflation, we also have to extend the model to allow
for changes in the stock of money.
For simplicity, we begin with situations in which the nominal interest
rate, R, and the inflation rate, ir, are constant over time. Therefore, the
real interest rate, r = R r is also constant. Because we assumed
equality between actual and expected inflation, ir = ir8, there is also
equality between actual and expected real interest rates, r = r8.
MONETARY GROWTH AND TRANSFER PAYMENTS
We choose the simplest possible way to introduce monetary growth into the
model: new money shows up as transfers from the government to households.
(Later we shall see that the main results still hold for other, more
realistic, methods of introducing new money into the economy.)
Denote by Vt the dollar amount of transfer that a household receives during
period t. This amount need not be the same for everyone. The goveminent
finances the total of transfers, Vt. by printing and distributing new
pmoney. Therefore,the change in aggregate quantity of money, Mt Mt-1
equals the aggregate demand of transfer
Vt =
Equation 8.1 is a simple version of a government budget constraint. The
left side is total government expenditures, all of which take the form of
trasnfer at the point. The right sid shows government revenues. At
present ,this revenue derives solely from the printing of new paper money

We can think of transfer payment as arising via a helicopter drop of

cash our public officials effectively stuff a helicopter
full of paper
currency and fly around dropping money randomly over the contryside. The
transfer payments occur when people pick up the money. Despite the
unrealistic flavor of this story, the only important aspect of it is that
each persons transfer is independent of his or her level income ,
previous amount of money holding,and so on economics refer to these kinds
of transfers as lump-sump transfer,which means that the among someone
receives is independent of his or her level of work effort,holdings of
money, or other activities . Since the transfers are lump sum,an
individual under stands that change in his or her holdings of money,m and
mt-1 have no impact on the size of his or her transfer
We have to modify household budget constraint to include the tranfer
payments each household budget constraint for period t is
As before, the source of funds on the left side include the dollar
recepits from the commodirty market ,py, plus the values of the bond and
money that were held last period bt-1 )1 +r). The new elemet is the
dollar amoung of transfers [Link] is additional source of funnds as
before. These are the nominal purchase of commodities p1c1,plus this period
holdings of bonds and money, bt +mt notice that we date the price
level,p, since it will no longer be constant over time,since we assume
that the nominal interest rate ,r , is costant,do not have date it
Budget constraint over an infinite horison
We have to make some adjustment to incorporate inflation into household
budget constraiint over an infinite [Link] put aside the varios
monetary terms, which include the initial stock of real money balance,
(the appendix to this chapter shows that this ommision is satisfactory)
Then ,where written in term of nominal present value, the budget
constraint over an infinite horizon looks basically like it did before,
Since we assume that the nominal interest rate R is constanr , the
condition is

P1y1 +P2y2/1 +R)+P3y3/(1 +R)2++b0(1 +R)

(8.3)
=P1c1 +P2c2/(1 +R)+P3c3/(1 +R2+
The only new element in equation (8.3) is the dating of the price level.
Recall that we assume a constant rate of inflation, it. Therefore. the
price levels for any two adjacent periods satisfy the condition P =
(1 + it) . Pt..i. We can use this condition repeatedly to express each
future
level of prices In terms of the current price. P1, and the inflation rate,
it,
to get the sequence:
P2 =(1 + it) P1,
P3=(1+ir)2P1.

1f we substitute these results into the budget constraint from equation

(8.3), theii we get the revised condition
P1. (y +y2 (1 +ir)/(1 + R) +3 (1 +it)2/(1 +R)2 + .. .1+ b0.(1 + R)
=P1(c1+c2(1+it/(1+Th+c3(1+it2/(1+R)2+.J (8.4)
. . , . .
Notice that the next period s real income and spending. y and C, enter
multiplicativoly with the factor 1 + it)/(1 + R). But recall from Chapter 7
that the relation between real and nominal interest rates is
(I+r)=(1+R)/(1+ir). The term in equation (8.4), (I+ir)/(1+R).
is therefore equal to 1/(1 + r. Hence, to express the next periods real
income and spending, y and c2, as present values, we (livide by the
discount factor, I + r. This result makes sense because the real interest
rate tells people how they can exchange goods of one period for those of
another. In particular, it is the reo) interest rate, rather than the
nominal
rate, that matters here.
The same idea applies for any future period. For example. the real income
and spending for period 3, y and c3, enter into equation (8.4) as a
multiple of the factor (1 + it)2/(1 + R)2, which equals 1/(1 + r)2. If we
make all these substitutions into equation (8.4)and also divide through by
the current price level. Pjthen we end up with a simplified form of
the budget constraint:
Yl +y/(1 +r)+y3/(1 +r)2+.+b0(1 +R)/P1 (85)
=Cl +C2/(1 +r)+c3/(1+r)2+...
(The nominal interest rate appears in the term b0. Li + Ri because this
term is the nominal value of the bonds carried over to period 1.)
Equation (8.5) is the budget constraint in real terms over an infinite
horizon. The new element is that the real interest rate, r. appears instead
of the nominal rate, R. in the various discount factors.
INTERTEMPORAL-SUBSTITUTON EFFECTS
We discussed before how the interest rate has intertoinporal-substitution
effects on consumption, leisure, and saving. These effects involve the
relative costs of taking consumption or leisure at one date rather than
another. In making these comparisons an individual wants to know, for
example, how much extra consumption he or she can get next period by
reducing consumption this period. As we worked out before an individual can
save and thus transform each unit of consumption forgone this period into I
+ r units of added consumption for the next period. An increase in the real
interest rate, r, motivates people to reduce current consumption and
leisure to raise future consumption and leisure. In other words, a higher r
motivates people to save more to day. The important point is that the real
interest rate matters here rather than the nominal rate. Thus, our previous

discussions of intertemporal substitution effects remain valid if we

replace the nominal interest rate by the real rate. Recall that in this
chapter we treat the real interest rate. r, as a known quantity. More
generally. the expected real interest rate, re = R 7.e is what matters for
intertemporal-substitution effects. Peo- pie do not shift their planned
time paths of consumption and leisure. and, hence, their saving, unless
they anticipate that the real interest rate will be either higher or lower.
For intertemporal-substitution effects to arise, there must be a change in
the nominal interest rate, R, relative to the expected rate of inflation.
INTEREST RATES AND THE DEMAND FOR MONEY
Recall that the demand for money involves a trade-off between transacttion
costs and interest forgone. Further. the interest forgone depends on the
differential between the interest rate on bonds and that on money. Since
the nominal interest rate on money is zero, this differential equals the
nominal interest rate, R (and not the real interest rate, r). It follow
that the demand-for-money function involves the nominal interest rate, R.
Therefore, as in our previous analysis that neglected inflation, the
function for the aggregate real demand for money takes the form
(Mt/Pt)1=(Yt, R,...) (8.6)
(+) ()
z
Notice an important point. Ills the real interest rate, r, that exerts
intertemporal-substitution effects on consumption and work. But it is the
nominal interest rate, R, that influences the real demand for money.
MARKET-CLEARING CONDITIONS
We know from Chapter 5 how to express the conditions for general market
clearing. First, the aggregate supply of goods, Y, equals the .! demand,
Cd:
t o
(8.7)
(N (+)
Equation (8.7) shows the intertemporal-substitution effects from the real
interest rate, t As usual, this effect is positivo on the supply of goods
and negative on the demand. The omitted terms, denoted b .. . . include
various aspects of the production function. Transaction costs associated
with cash management would generally enter hero through wealth effects. but
we are assuming that these influences are small enough to neglect.
Second, we have the condition thai all money be willingly held. we can
write this condition for period t as
M, = P,. ( Y,, R,, ...) (8.8)
(+t I)
On the left is the actual quantity of money. On the right is the nominal
demand for money, which depends positively on the price level, P. and
aggegate output, Y,, and negatively on the nominal interest rato, R. Any

other factors that influence money demand, such as transact ion costs, are
denoted by the expression . . . in equation (8.8). We assume that those
factors do not change over time.
THE SUPERNEUTRALITY OF MONEY
Before we exploro the details of the link between monetary behavior and
inflation, we can already soc an important property from the condition for
clearing the commodity market. Consider the underlying real factors : in
the model, which include the forms of production functions, the vel of
population, and the preferences of households. More generally, the
transaction costs associated with cash management would also appear on this
list, but we are assuming that these costs can be ignored. The various real
elements enter Lnto the demand and supply of commodities through the
omitted terms, which we denote b . . . in equation (8.7).For given values
of theso elements, equation (8.7) determines the real interest rate, F. and
the level of aggregate output. Y, = C,, at each date. If the underlying
real elements do not change over timo, then the market- clearing values of
the real interest rate and output are constants.
The important point is not that the real interest rate and output are
constant but rather that they are determinad independently of the path of
money. At least this result holds if we maintain the approximation that the
transaction costs of cash management are small enough to negleci. Although
changes in money will and up affecting the paths of the price level and the
nominal interest rate, these monetary changes will, as an approximation,
not affect some of the real variables in the model.
If all real variables are invariant with the behavior of money. Then
economists say that money is superneutral. lhe phrase superneutrality of
money indicates an extension of another concept, the neutrality of money,
which we discussed before. Neutrality of money means that once-and-for-all
changes in the quantity of money affect nominal variables but not real
variables. Superneutrality extends this idea from one- time changes in the
stock of money to arbitrary variations in the entire path of money.
We know from before that money is neutral in the model. One point we want
to consider in this chapter is vhether money is superneutral. To the extent
that money is not superneutral, we shall find some effects of money and
inflation on real variables.
MONETARY GROWTH, INFLATION, AND THE NOMINAL INTEREST RATE
We want now to examine the details of the linkages among monetary growth,
inflation, and the nominal interest rate. We carry out this analysis for
given values of the real interest rate, r. and output. Y. By holding
these variables fixed, we are making two types of assumptions. First, we
use the property that anticipated variations in money and prices do not (as
an approximation) affect the real interest rate and output. Second. We
assume that no other shifts occur over time to the functions for aggregate
commodity demand and supply. Generally, these types of changes would lead
to movements in the real interest rate and output.
More specifically, the analysis neglects any systematic growth of output.
Recall from chapter 7 that countries with higher average growth rates of
output tend to have less inflation for a given average growth rate of
money . Althrough it is not hard to incorporatte this feature into the
analys is ,we assume that output is constant bring out the major points
in the easiest possible way

We can illustrate the main result by assuming a constant rate o f

monetary growth. In this case we have :
Where u (the greek letter mu) is the monetary growth rate . Assume that
equation 8.9 governs the behavior of money from the current date,t =w,
into the imdefinate future
We want to calculate the price level at each date ,,given that oney grows
at a constant rate. Generally the model detemines the time path of price
from the market clearing conditions that we mentioned before , but we
already determined the real interest rate and output to equate
aggregatte commoduty supply and demand in equation 8.7. Further,if the
supply and demand function do not shift over time,level P,, must satisfy
the condition that money be willingly held . Writing this condition in
real term, we have
In chapter we found that once and for all increases in the quantity of
money raised the price level ,p,, grows at the same rate as the money
stock,M, in this case the inflation rate ,I, is constant and equal to
the rate of monetary growth,u, so lets make this guess and see whether it
accords with the condition equation 8,10 that all money be willingly
held
If money and price level at the same rate, the ratio of these two,which is
the level of real money balance,m/p, does not change over time. Therefore,
the level of real money ,which appears on the left side of equation
8.10 is constant
Recall that the nominal interest rate,R,equals the quantity r + r , but
already know that the real interest rate is constant. This result means
that the real demand for money,L, which appears on the right side of
equation 8.10,is constant (remember that output ,Y, does not change over
time
Since real money balance and real amount of money demanded are each
constant ,we have only to be sure that the two constant are the same. This
constant holds if we determine the current price level p, to equate the
amount of real money balance,M/P,to the real quantity
demanded,L,Then,since actual and desired real money do not vary over time,
we can be sure that all money will be willingly held at each date,that
is ,equation 8.10 holds in every period
We have now verified that our guess- where price grow at the same
rate,as mone- satisfies the condition for general market clearing.
Therefore, this path of price is the one that will prevall. To summarize,
the result are as follows

Price grow the same rate as the money stock- that is , r = u

Aggregate real money balance,m/p, are constant
The nominal interest rate,R, is constant and equal to r + r
The agregate demand for real balance ,L(Y,R,) is constant
The current price price level p, equates the quantity of real money
balance m/p, to the real amount deteminded ,L(Y,R)

This results imply that the growth rate of money ,u, show up one for one
inflation rate ,r, and the nominal interest rate,R = r + R. But recall
higher nominal inerest rate means a lowel level of real money

demanded. Them a higher growth rate of money

aggregate real money balance M/p

corresponds to a lower af