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What causes inflation?
© 2019 Pearson
Money, Interest,
and Inflation
12
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Explain what determines the demand for money and
how the demand for money and the supply of money
determine the nominal interest rate.
2 Explain how in the long run, the quantity of money
determines the price level and money growth brings
inflation.
3 Identify the costs of inflation and the benefits of a
stable value of money.
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WHERE WE ARE AND WHERE WE’RE HEADING
The Real Economy
Real factors that are independent of the price level
determine potential GDP and the natural unemployment
rate.
Investment demand and saving supply determine the
amount of investment, the real interest rate and, along
with population growth, human capital growth, and
technological change, determine the growth rate of real
GDP.
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WHERE WE ARE AND WHERE WE’RE HEADING
The Money Economy
Money—the means of payment—consists of currency
and bank deposits.
Banks create money and the Fed influences the quantity
of money through its open market operations, which
determines the monetary base and the federal funds
rate.
Here we explore the effects of money on the economy.
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WHERE WE ARE AND WHERE WE’RE HEADING
Real and Money Interactions and Policy
The effects of money can be best understood in two
steps:
• The effects of the Fed’s actions on the short-term
nominal interest rate
• The long-run effects of the Fed’s actions on the price
level and the inflation rate
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12.1 MONEY AND THE INTEREST RATE
The Demand for Money
Quantity of money demanded is the amount of
money that households and firms choose to hold.
Benefit of Holding Money
The benefit of holding money is the ability to make
payments.
The more money you hold, the easier it is for you to
make payments.
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12.1 MONEY AND THE INTEREST RATE
The marginal benefit of holding money decreases as the
quantity of money held increases.
Opportunity Cost of Holding Money
The opportunity cost of holding money is the interest
forgone on an alternative asset.
Opportunity Cost: Nominal Interest Is a
Real Cost
The opportunity cost of holding money is the nominal
interest because it is the sum of the real interest rate on
an alternative asset plus the expected inflation rate,
which is the rate at which money loses buying power.
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12.1 MONEY AND THE INTEREST RATE
The Demand for Money Schedule and Curve
The demand for money is the relationship between
the quantity of money demanded and the nominal
interest rate, when all other influences on the amount of
money that people want to hold remain the same.
Figure 12.1 on the next slide illustrate the demand for
money.
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12.1 MONEY AND THE INTEREST RATE
The lower the
nominal interest
rate—the
opportunity cost
of holding
money—the
greater is the
quantity of money
demanded.
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12.1 MONEY AND THE INTEREST RATE
Other things
remaining the
same,
A rise in the
nominal interest
rate decreases
the quantity of
real money
demanded.
A fall the nominal interest rate
increases the quantity of money
demanded.
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12.1 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 money demanded.
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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12.1 MONEY AND THE INTEREST RATE
The Price Level
An x percent rise in the price level brings an x percent
increase in the quantity of money that people plan to
hold because the number of dollars we need to make
payments is proportional to the price level.
Real GDP
The demand for money increases as real GDP increases
because expenditures and incomes increase when real
GDP increases.
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12.1 MONEY AND THE INTEREST RATE
Financial Technology
Changes in technology change the demand for money.
Daily interest on checking deposits, automatic transfers
between checking and savings accounts, automatic
teller machines, debit cards, and smart cards have
increased the marginal benefit of money and increased
the demand for money.
Credit cards have made it easier to buy goods and
services on credit and have decreased the demand for
money.
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12.1 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 is determined by the
actions of the banking system and the Fed.
On any given day, the quantity of money is fixed
independent of the interest rate.
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12.1 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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12.1 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 12.2 on the next slide illustrates money market
equilibrium and the adjustment toward equilibrium.
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12.1 MONEY AND THE INTEREST RATE
If the interest rate is 6
percent a year, the
quantity of money held
exceeds the quantity
demanded.
People buy bonds, the
price of a bond rises, and
the interest rate falls.
As the nominal interest
rate falls, the quantity of
money demanded
increases.
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12.1 MONEY AND THE INTEREST RATE
If the interest rate is 4
percent a year, the
quantity of money held is
less than the quantity
demanded.
People sell bonds, the
price of a bond falls, and
the interest rate rises.
A rise in the nominal
interest rate decreases
the quantity of money
demanded.
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12.1 MONEY AND THE INTEREST RATE
If the interest rate is 5
percent a year, the
quantity of money held
equals the quantity
demanded.
The money market is in
equilibrium.
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12.1 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.
If the price of the bond falls, the interest rate rises.
If the price of the bond rises, the interest rate falls.
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12.1 MONEY AND THE INTEREST RATE
Interest Rate Adjustment
• When the interest rate is above its equilibrium level,
the quantity of money supplied exceeds the quantity
of money demanded.
• People are holding too much money, so they try to get
rid of money by buying other financial assets.
• The demand for financial assets increases, the prices
of these assets rise, and the interest rate falls.
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12.1 MONEY AND THE INTEREST RATE
Conversely,
• When the interest rate is below its equilibrium level,
the quantity of money demanded exceeds the quantity
of money supplied.
• People are holding too little money, so they try to get
more money by selling other financial assets.
• The demand for financial assets decreases, the prices
of these assets fall, and the interest rate rises.
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12.1 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 12.3 on the next slide illustrates these changes.
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12.1 MONEY AND THE INTEREST RATE
If the Fed increases the
quantity of money and the
supply of money curve
shifts to MS1, the interest
rate falls to 4 percent a
year.
If the Fed decreases the
quantity of money and the
supply of money curve
shifts to MS2, the interest
rate rises to 6 percent a
year.
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12.2 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 the effects of the business cycle.
In the short run, the interest rate adjusts to make the
quantity of money demanded equal the quantity of
money supplied.
In the long run, the price level does the adjusting.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Long-Run Demand for Money
In the long run, equilibrium in the market for loanable
funds determines the real interest rate.
The nominal interest rate that influences money holding
plans equals the real interest rate plus the inflation rate.
If the inflation rate is zero, the nominal interest rate in the
long run equals the real interest rate.
The interest rate is determined by real forces.
The variable that adjusts in the long run is the “price” of
money.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The lower the “price” of money, the greater is the
quantity of money that people are willing to hold.
The “price” of money is the value of money.
The Value of Money
The value of money is the quantity of goods and
services that a unit of money will buy.
It is the inverse of the price level, P, which equals the
GDP price index divided by 100. That is,
Value of money = 1/P.
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12.2 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 forces in the long run and
are given.
In the long run, money market equilibrium determines
the value of money.
Figure 12.4 on the next slides illustrates the long-run
money market equilibrium.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The long-run demand for
money is determined by
potential GDP and the
equilibrium interest rate.
The LRMD curve shows
how the quantity of money
that households and firms
plan to hold, in the long
run, depends on the value
of money.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The MS curve shows the
quantity of money
supplied, which is $1
trillion.
The price level adjusts to
make the value of money
equal to 1 and achieve
long-run money market
equilibrium.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
A Change in the Quantity of Money
Starting from a long-run equilibrium, suppose that the
Fed increases the quantity of money by 10 percent.
In the short run, the greater quantity of money lowers the
nominal interest rate.
With the lower interest rate, people and firms spend
more.
But with real GDP equal to potential GDP, prices start to
rise.
At the new long-run equilibrium, the price level will have
risen by 10 percent, from 1.0 to 1.1.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
Figure 12.5 illustrates the
long-run outcome.
The quantity of money
increases by 10 percent
from $1 trillion to $1.1
trillion and the supply of
money curve shifts from
MS0 to MS1.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The price level rises by
10 percent and the
value of money falls by
10 percent to restore
long-run equilibrium in
the money market.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
A key proposition about the quantity of money and the
price level is that:
In the long run and other things remaining the same, a
given percentage change in the quantity of money brings
an equal percentage change in the price level.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Price Level in a Baby-Sitting Club
A baby-sitting club uses tokens to pay for neighbor’s
baby-sitting services. One sitting costs one token.
The organizers double the number of tokens by giving a
token to each member for each token currently held.
Equilibrium in this local baby-sitting market is restored
when the price of sit doubles to two tokens.
Nothing real has changed, but the nominal quantity of
tokens and the price level have doubled.
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12.2 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, an increase in the
quantity of money brings an equal percentage increase
in the price level (other things remaining the same).
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Velocity of Circulation and Equation of
Exchange
Velocity of circulation is the number of times in a
year that the average dollar of money gets used to buy
final goods and services.
Equation of exchange is an equation that states that
the quantity of money multiplied by the velocity of
circulation equals the price level multiplied by real GDP.
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12.2 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
MV=PY
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Quantity Theory Prediction
The equation of exchange, M V = P Y, implies that
P = (M V) Y.
On the left is the price level and on the right are all the
things that influence the price level.
These influences are the quantity of money, the velocity
of circulation, and real GDP.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
To turn the equation into a theory of what determines the
price level, we use two facts:
[Link] the long run, real GDP equals potential GDP, which
is independent of the quantity of money.
[Link] velocity of circulation is relatively stable and does
not change when the quantity of money changes.
So, in the long run, V and Y are constant and the price
level P is proportional to the quantity of money M.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
Inflation and the Quantity Theory of Money
The equation of exchange tells us the relationship
between the price level, the quantity of money, the
velocity of circulation, and real GDP.
This equation implies a relationship between the rates of
change of these variables, which is
Money growth + Velocity growth =
Inflation rate + Real GDP growth
Figure 12.6 on the next slide illustrates the relationship.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The velocity of circulation grows at 1 percent a year and
real GDP grows at 3 percent a year.
If the quantity of
money grows at
2 percent a year,
the inflation rate
is zero.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The velocity of circulation grows at 1 percent a year and
real GDP grows at 3 percent a year.
If the quantity of
money grows at
4 percent a year,
the inflation rate
is 2 percent a
year.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
The velocity of circulation grows at 1 percent a year and
real GDP grows at 3 percent a year.
If the quantity of
money grows at
10 percent a year,
the inflation rate is
8 percent a year.
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12.2 MONEY, THE PRICE LEVEL, AND INFLATION
A Change in the Inflation Rate
Because, in the long run, both velocity growth and real
GDP growth are independent of the growth rate of
money: …
A change in the money growth rate brings an equal
change in the inflation rate.
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12.2 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 a month is
called hyperinflation.
50 percent a month is 12,875 percent per year.
The highest inflation rate in recent times was in
Zimbabwe, where inflation peaked at 231,150,888.87
percent a year in July 2008.
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12.3 THE COST OF INFLATION
Inflation is costly for four reasons:
• Tax costs
• Shoe-leather costs
• Confusion costs
• Uncertainty costs
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12.3 THE COST OF INFLATION
Tax Costs
Government gets revenue from inflation.
Inflation Is a Tax
You have $100 and you could buy 10DVDs ($10 each)
today or hold the $100 as money.
If the inflation rate is 5 percent a year, at the end of the
year the 10DVDs will cost you $105.
If you held $100 as money for the year, you have paid a
tax of $5 on your holding $100 of money.
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12.3 THE COST OF INFLATION
Inflation, Saving, and Investment
The income tax on nominal interest income drives a wedge
between the before-tax interest rate paid by borrowers and
the after-tax interest rate received by lenders.
The fall in the after-tax interest rate weakens the incentive
to save and lend.
The rise in the before-tax interest rate weakens the
incentive to borrow and invest.
Inflation increases the nominal interest rate, and because
income taxes are paid on nominal interest income, the true
income tax rate rises with inflation.
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12.3 THE COST OF INFLATION
The higher the inflation rate, the higher is the true
income tax rate on income from capital.
And the higher the tax rate, the higher is the interest rate
paid by borrowers and the lower is the after-tax interest
rate received by lenders.
With a fall in saving and investment, capital
accumulation and real GDP growth slows.
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12.3 THE COST OF INFLATION
Shoe-Leather Costs
So-called “shoe-leather” costs arise from an increase in
the velocity of circulation of money and an increase in
the amount of running around that people do to try to
avoid incurring losses from the falling value of money.
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12.3 THE COST OF INFLATION
When money loses value at a rapid anticipated rate, it
does not function well as a store of value and people try
to avoid holding it.
They spend their incomes as soon as they receive them,
and firms pay out incomes—wages and dividends—as
soon as they receive revenue from their sales.
The velocity of circulation increases.
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12.3 THE COST OF INFLATION
Confusion Costs
Money is our measuring rod of value.
Borrowers and lenders, workers and employers, all
make agreements in terms of money.
Inflation makes the value of money change, so it
changes the units on our measuring rod.
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12.3 THE COST OF INFLATION
Uncertainty Costs
A high inflation rate brings increased uncertainty about
the long-term inflation rate.
Increased uncertainty also misallocates resources.
Instead of concentrating on the activities at which they
have a comparative advantage, people find it more
profitable to search for ways of avoiding the losses that
inflation inflicts.
Gains and losses occur because of unpredictable
changes in the value of money.
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12.3 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 is its cost.
And the more unpredictable the inflation rate, the greater
is its cost.
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According to the quantity theory of money, whether we face
a future with inflation, deflation, or a stable price level
depends entirely on the rate at which the Fed permits the
quantity of money to grow.
But is the quantity theory correct?
Does it explain our past inflation with enough accuracy to
be a guide to future inflation?
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The quantity theory does not predict the year-to-year
changes in the inflation rate.
The quantity theory does an especially bad job of
explaining 2008 and 2009 because in those years, the
velocity of circulation tumbled.
But on average, over a number of years, the quantity
theory is a remarkably accurate predictor of the inflation
rate.
The figure (on the next slide) shows that the quantity
theory explains our inflation rates since the 1960s.
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The 1960s and 1970s
The quantity theory
does a perfect job of
explaining inflation in
these two decades.
The inflation rate
(green bar) equaled
the M2 growth rate
(blue bar) minus the
real GDP growth rate (red bar).
Velocity of circulation of M2 was constant.
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During the 1970s the
M2 growth rate
increased,
real GDP growth was
slowed,
and the inflation rate
rose.
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The 1980s and 1990s
During the1980s, M2
growth rate slowed,
M2 velocity increased,
and real GDP growth
was steady.
The inflation rate fell.
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EYE o the CAUSE OF INFLATION
During the 1990s,
M2 growth slowed,
M2 velocity increased,
real GDP remained
steady, and
the inflation rate fell.
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EYE on the CAUE OF INFLATION
The 2000s and 2010s
In these decades, the
M2 growth rate
increased but the
inflation rate
decreased.
The changes in
inflation are the
opposite of what the
quantity theory
predicts.
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EYE on the CAUE OF INFLATION
The reason is that the
velocity of circulation
fell (the yellow bars
and down-arrows).
Velocity fell because
interest rates were
lowered by the Fed to
unprecedented levels.
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