Lectures in Macroeconomics- Charles W. Upton More on the Basics of the Demand for Money r N = r R +  + r R  r N  r R + 

More on the Basics of the Demand for Money 2 The Nominal Rate Interest stated in money. I lend you 100 pictures of George; you promise to give me 106 back. r N = 6%

More on the Basics of the Demand for Money 3 The Real Rate Interest stated in purchasing power. I lend you enough to purchase 100 slices of pizza; you promise to repay me enough to purchase 103. r R = 3%

More on the Basics of the Demand for Money 4 The Relation I have promised you a real return of r R The inflation rate is  What kind of nominal return (r N ) have I promised?

More on the Basics of the Demand for Money 5 The Relation [$100(1+r R )] Amount due with no inflation

More on the Basics of the Demand for Money 6 The Relation [$100(1+r R )](1+  ) Inflation adjustment

More on the Basics of the Demand for Money 7 The Relation [$100(1+r R )](1+  ) = $100(1+r N ) Amount due in nominal terms

More on the Basics of the Demand for Money 8 The Relation [$100(1+r R )](1+  ) = $100(1+r N )

More on the Basics of the Demand for Money 9 The Relation (1+r R )(1+  ) = (1+r N )

More on the Basics of the Demand for Money 10 The Fisher Equation (1+r N )= (1+r R )(1+  ) r N = r R +  + r R  r N  r R + 

More on the Basics of the Demand for Money 11 An Aside r N = r R +  + r R  r N  r R + 

More on the Basics of the Demand for Money 12 How good is the approximation r R = 3%  = 2%

More on the Basics of the Demand for Money 13 How good is the approximation r R = 3%  = 2% r N = r R +  + r R 

More on the Basics of the Demand for Money 14 How good is the approximation r R = 3%  = 2% r N = r R +  + r R  = (0.03)(0.02) =0.0506

More on the Basics of the Demand for Money 15 How good is the approximation r R = 3%  = 2% r N = r R +  + r R  = r N  r R +  = 0.05

More on the Basics of the Demand for Money 16 How good is the approximation r R = 3%  = 2% r N = r R +  + r R  = r N  r R +  = 0.05 r R = 50%  = 50%

More on the Basics of the Demand for Money 17 How good is the approximation r R = 3%  = 2% r N = r R +  + r R  = r N  r R +  = 0.05 r R = 50%  = 50% r N = r R +  + r R 

More on the Basics of the Demand for Money 18 How good is the approximation r R = 3%  = 2% r N = r R +  + r R  = r N  r R +  = 0.05 r R = 50%  = 50% r N = r R +  + r R  = (0.50)(0.50) =1.25

More on the Basics of the Demand for Money 19 How good is the approximation r R = 3%  = 2% r N = r R +  + r R  = r N  r R +  = 0.05 r R = 50%  = 50% r N = r R +  + r R  =1.25 r N  r R +  = 1.00

More on the Basics of the Demand for Money 20 How good is the approximation r R = 3%  = 2% r N = r R +  + r R  = r N  r R +  = 0.05 r R = 50%  = 50% r N = r R +  + r R  =1.25 r N  r R +  = % versus 5.06%. Not bad

More on the Basics of the Demand for Money 21 How good is the approximation r R = 3%  = 2% r N = r R +  + r R  = r N  r R +  = 0.05 r R = 50%  = 50% r N = r R +  + r R  =1.25 r N  r R +  = % versus 125%. Pretty bad

More on the Basics of the Demand for Money 22 End of Aside

More on the Basics of the Demand for Money 23 Prices Double Every Year Which rate should we use here? The real or the nominal?

More on the Basics of the Demand for Money 24 Prices Double Every Year r N, the nominal rate, for money is a nominal asset. The interest we lose by being in money is a nominal rate.

More on the Basics of the Demand for Money 25 Prices Double Every Year Wealth calculations and the like can be done either in real rates if we discount real (inflation adjusted) cash flows or in nominal rates if we discount nominal cash flows.

More on the Basics of the Demand for Money 26 Prices Double Every Year Intuitively, money is subject to “depreciation”, that is the loss of value as a function of inflation, and including a term for inflation captures this effect.

More on the Basics of the Demand for Money 27 Properties of Money Demand Function Demand for nominal money balances rises in proportion to prices. Demand for real money balances rises with income. Demand for money balances is a function of the nominal interest rate.

More on the Basics of the Demand for Money 28 End ©2005 Charles W. Upton. All rights reserved