1. Money, Interest Rate and Inflation
Chapter 13

2. Money and the Interest Rate
Demand for money
There are benefit and cost of holding money.
The benefit of holding money is the convenience of making payments and do transactions.
The opportunity cost of holding money is the nominal interest rate foregone on an alternative asset (e.g. bonds and CDs)
Given constant benefit of holding money, the higher the nominal interest rate, the smaller is the quantity of money demanded.
Downward-sloping demand curve for money

3. Money and the Interest Rate (Continued)
Shifts in the demand for money curve
Changes in the price level
Changes in real GDP
Changes in financial technology
Supply of money
Fixed (vertical curve) at a given point of time
The supply of and demand for money will determine the equilibrium nominal interest rate.

4. Money and the Interest Rate (Continued)
Nominal interest rate
Nominal interest rate = real interest rate + inflation rate
The interest rate and bond price move in opposite directions
The Fed can affect the nominal interest rate
Discount rate federal funds rate  prime rate
Change in money supply  change in the nominal interest rate

5. Money and Inflation Equation of Exchange Quantity Theory of Money
M V = P Y (or Q)
Velocity of money: the average number of times money spent on purchase of final products
Quantity Theory of Money
Velocity (V) and aggregate output (Y or Q) are unaffected by a change in money supply
A change in money supply (M) will result in a proportional change in the price level (P)

6. Money and Inflation Continued
Short-run vs. long-run
In the short-run, the money supply increase causes a fall in the nominal interest rate.
However, in the long–run, the money supply increase also results in the higher price level, causing increase in the demand for money.
So, the nominal interest rate returns to its long-run equilibrium level.

7. Monetarism A school of economic thought founded by Milton Friedman
Modern version of the quantity theory
Rule-based money supply rather than discretionary monetary policy
Increase money supply at a steady rate equal to or slightly larger than the long run growth in output
At 3% or slightly higher

8. Effects and Costs of Inflation
Inflation is a tax: transfer of resources from the private sector to government
Inefficient use of time and resources
Confusion and uncertainty discourage savings and investment  decrease in output and slowdown in economic growth
The cost of inflation depends on the degree of inflation
Mild inflation (3% or less): small
Hyper-inflation: great