Chapter 27: Money, Interest, and Inflation The Money Market The Velocity of Money The Equation of Exchange

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+ = THE DEMAND FOR MONEY Transactions Demand, Dt Asset Demand, Da Total demand for money, Dm Rate of interest, i (percent) Amount of money demanded (billions of dollars) Dt 10 7.5 5 2.5 0 50 100 150 200 250 300 Rate of interest, i (percent) Amount of money demanded (billions of dollars) 10 7.5 5 2.5 Da Rate of interest, i (percent) Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 10 7.5 5 2.5 Dm 0 50 100 150 200 250 300

27.1 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. We hold cash in times of uncertainty. We hold cash to pay bills and consume in an immediate sense. Opportunity cost of holding cash - when the interest rate is high the opportunity cost of holding money is high which means quantity demanded is low; when the interest is low, the opportunity cost of holding money is low (QD is high). The interest rate that we are referring to is called the nominal interest rate. Nominal Interest Rate= Real Interest Rate + Inflation rate The demand for money curve is unlike any other demand curve the students have met before. It is a demand curve for a stock to hold, not a demand curve for a flow to use. The interest rate on the next best alternative asset is the opportunity cost of holding money, which means that it is the relevant price against which we draw the demand for money curve. Student’s find these ideas difficult and they need to be explained carefully.

27.1 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. Ex: A higher interest rate at the bank tells me to hold less cash, a lower one makes me hold more cash.

27.1 MONEY AND THE INTEREST RATE Other things remaining the same, 1. An increase in the nominal interest rate decreases the quantity of real money demanded. 2. A decrease in the nominal interest rate increases the quantity of money demanded.

27.1 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 that shift Dm: Changes to the price level Changes in Real GDP Changes in Financial Technology

Money Markets

27.1 MONEY AND THE INTEREST RATE Financial Technology 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 because it’s easier to pay with a credit card then to get money.

27.1 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 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.

27.1 MONEY AND THE INTEREST RATE 2. 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.

27.1 MONEY AND THE INTEREST RATE The Supply of Money The supply of money is shown by a vertical line on the graph. It’s vertical because it’s unrelated to interest rates. 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. We are careful to maintain the hard-learned distinction between supply and quantity supplied. We use the term “supply of money” to mean the supply schedule or curve and not the “quantity of money.”

27.1 MONEY AND THE INTEREST RATE The Nominal Interest Rate The FED adjusts the supply of money to change the interest rate. They do this by using expansionary or contractionary monetary policy. When they set policy the interest rate will move and the Dm will move to meet the Sm. There are three shifters of the Sm: reserve requirement, discount rate, and OMO.

Shifters of the Money Supply

27.1 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 27.3 on the next slide illustrates these changes.

27.1 MONEY AND THE INTEREST RATE 1. 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. 2. 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.

27.1 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. Spend a bit of time explaining the inverse relationship between the interest rate and the price of a bond. Use a numerical example: if the interest payment on a bond is $5 per year, when the price of the bond is $100, the interest rate is 5 percent; when the price of the bond is $50, the interest rate is 10 percent; and when the price of the bond is $200, the interest rate is 2.5 percent. Bond holders like the interest rate to fall—like the prices of bonds to rise.

27.1 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.

27.1 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.

27.2 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. The Fed can influence short term interest rates in the short run. But in the long run, the Fed must come into line with more fundamental market forces. In the market loanable funds, long-term interest rates balance supply and demand at a nominal interest rate that incorporates the expected long-term inflation rate. Other (short term) interest rates align with the long term rate because long term and short term bonds are close substitutes. Given the equilibrium interest rate, if the quantity of money exceeds the quantity that people want to hold, they spend the excess and the price level rises.

27.2 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.

27.2 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.

27.2 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 27.4 on the next slides illustrates the long-run money market equilibrium.

27.2 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.

27.2 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 1 and achieve long-run money market equilibrium.

27.2 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 equilibrium, the price level will have risen by 10 percent, from 1.0 to 1.1.

27.2 MONEY, THE PRICE LEVEL, AND INFLATION Figure 27.5 illustrates the outcome. 1. 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.

27.2 MONEY, THE PRICE LEVEL, AND INFLATION 2. The price level rises by 10 percent and the value of money falls by 10 percent to restore long-run money market equilibrium.

27.2 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.

27.2 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 sit 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. You might want to run an in-class experiments to demonstrate the quantity theory of money. Here is game #162 from http://www.marietta.edu/~delemeeg/games/games161-170.htm “Students are randomly allocated five poker chips of varying color (red, white, blue) to serve as money in a series of auctions.  Chip values for the first series of auctions are: red = 25, white = 50, and blue = 100.  Candy and granola bars are then auctioned off with prices posted on the chalkboard.  For the second series of auctions, students exchange their poker chips with another student and a new set of values are revealed: red = 50, white = 100, and blue = 200.  Predictably, the prices of the candy and granola bars will approximately double.”

27.2 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).

27.2 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.

27.2 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

27.2 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.

27.2 MONEY, THE PRICE LEVEL, AND INFLATION To turn the equation into a theory of what determines the price level, we use two facts: 1. In the long run, real GDP equals potential GDP, which is independent of the quantity of money. 2. The 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.

27.2 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 27.6 on the next slide illustrates the relationship.

27.2 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.

27.2 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.

27.2 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.

EYE on the CAUSE OF INFLATION Does Inflation, Deflation, or a Stable Price Level Lie in Our Future? 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? 40

EYE on the CAUSE OF INFLATION Does Inflation, Deflation, or a Stable Price Level Lie in Our Future? 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 past decade average inflation rates. 41

EYE on the CAUSE OF INFLATION Does Inflation, Deflation, or a Stable Price Level Lie in Our Future? During the 1960s: M2 velocity was constant, the quantity of M2 grew at 6.7 percent a year, real GDP grew at 4.4 percent a year, and the inflation rate was 2.3 percent a year. 42

EYE on the CAUSE OF INFLATION Does Inflation, Deflation, or a Stable Price Level Lie in Our Future? During the 1970s: M2 velocity was constant, the M2 growth rate increased, real GDP growth was slowed, and the inflation rate rose. 43

EYE on the CAUSE OF INFLATION Does Inflation, Deflation, or a Stable Price Level Lie in Our Future? During the 1980s: M2 velocity was constant, the M2 growth rate slowed, real GDP growth was steady, and the inflation rate fell. 44

EYE on the CAUSE OF INFLATION Does Inflation, Deflation, or a Stable Price Level Lie in Our Future? During the 1990s: M2 velocity increased, M2 growth slowed, real GDP remained steady, and the inflation rate fell. 45

EYE on the CAUSE OF INFLATION Does Inflation, Deflation, or a Stable Price Level Lie in Our Future? During the 2000s: M2 velocity decreased, M2 growth increased, real GDP fell, and the inflation rate remained steady. 46

27.2 MONEY, THE PRICE LEVEL, AND INFLATION Changes 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.

27.2 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. Highest inflation rate in recent times was in Zimbabwe, where inflation peaked at 231,150,888.87 percent a year in July 2008.

27.3 THE COST OF INFLATION Inflation is costly for four reasons: Tax costs Shoe-leather costs Confusion costs Uncertainty costs

Tax Costs 27.3 THE COST OF INFLATION 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 the end of the year the 10 CDs 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.

27.3 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.

27.3 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.

Shoe-Leather Costs 27.3 THE COST OF INFLATION 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.

27.3 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.

Confusion Costs 27.3 THE COST OF INFLATION 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.

Uncertainty Costs 27.3 THE COST OF INFLATION 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.

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.