1. Money, Interest, and Inflation
Chapter 27

2. Quantity of Money Demanded
The amount of money that households and firms choose to hold
What determines QMD?
Price of Money (can be thought of in two ways)
The Value of Money
Opportunity Cost of Money
Households must compare the benefit from holding money to its OC

3. OC of Holding Money
Forgone interest or the goods/services that could have been purchased with that interest
If an investment pays back 10% in dividends every year, what is the opportunity cost of holding $100 instead of investing the $100?
$100(.10) = $10
OC = anything you could have purchased with that $10

4. OC = Nominal Interest Rate
Nominal Interest Rate = Real Interest Rate + Inflation Rate
The higher the nominal interest rate, the smaller is the quantity of money demanded

5. Demand for Money (MD)
The relationship between the quantity of money demanded and the nominal interest rate
Nominal Interest Rate MD
Quantity of Money

6. Changes in the Nominal Interest Rate
When the nominal interest rate increases, the opportunity cost of holding money increases, which causes the quantity of money demanded to decrease.
Nominal Interest Rate B
inB A
inA MD QB QA
Quantity of Money

7. Demand for Money Influences
Price Level (PL)
When PL increases by x%, MD increases by x%.
Real GDP
When real GDP increases, MD increases.
Financial Technology
Credit cards decrease MD since it increases the OC of holding money

8. Sketch the Effects #1
When price levels fall, the demand for money shifts which direction?

9. Sketch the Effects #2
When real GDP increases, the demand for money shifts which direction?

10. Supply of Money (MS)
The relationship between the quantity of money supplied and the nominal interest rate
Determined by the actions of the banking system and the Fed
On any given day, the quantity of money is fixed. MS
Nominal Interest Rate
Quantity of Money

11. Money Market EquilibriumMS
Nominal Interest Rate in MD QM
Quantity of Money

12. Bond Prices
An investment that promises to pay periodic interest payments along with the face value on the maturity date.
Ex. $1,000 bond with a 20% interest rate paid quarterly for 2 years
Each quarter you will receive 5% interest or $50 (1,000 x .05)
You purchase the bond for $1,000, and by the end of the 2 years, you receive 1, (8) = $1,400.

13. How Changing Interest Rates Affect Bond Prices
Ex. $1,000 bond with a 20% interest rate paid quarterly for 2 years
Assume interest rates decrease to 15%.
How does this impact the price of this bond?

14. Interest rates and bond prices move in opposite directions

15. When interest rates are above market equilibrium
There is an excess supply of money
Price of bonds decrease
People buy bonds, which lowers the interest rate to market equilibrium MS
Nominal Interest Rate i1 in MD
QMD
QMS
Quantity of Money

16. When interest rates are below market equilibrium
There is an excess demand for money
Price of bonds increases
People sell bonds, which raises the interest rate to market equilibrium MS
Nominal Interest Rate in i1 MD
QMS
QMD
Quantity of Money

17. Lowering the Interest Rate
Monetary Action: Fed increases the MS
MS2 MS
Nominal Interest Rate in i2 MD QM
QM2
Quantity of Money

18. Raising the Interest Rate
Monetary Action: Fed decreases the MS
MS2 MS
Nominal Interest Rate i2 in MD
QM2 QM
Quantity of Money

19. Review How does the Fed control the money supply?
A: purchasing and selling bonds

20. Open Market Operations
If the Federal Reserve wants to lower interest rates, what open market operation will it institute?
If the Federal Reserve wants to raise interest rates, what open market operation will it institute?

21. Sketch the Effects #3 Sketch a money market graph
Illustrate the net effect of the Fed purchasing government securities in the open market.

22. Sketch the Effects #4 Sketch a money market graph
Illustrate the net effect of the Fed selling government securities in the open market.

23. Money, the Price Level, and Inflation
Chapter 27.2

24. The Long Run
The economy at full employment when real GDP equals potential GDP

25. The Value of Money
The quantity of goods and services that a unit of money will buy
Value of Money
= 1/PL
= 1/(GDP Price Index/100)
= 100/GDP Price Index
As the price level rises, the value of money falls

26. Value of Money Example
The nominal price of a t-shirt is $20. The GDP deflator is 125. What is the real price of a t-shirt?
You have $100 in your wallet. Price levels rise by 10%. How much is that $100 really worth?
You have $500 in your wallet. Price levels fall by 25%. How much is that $500 really worth?
20/1.2 = 200/12 = 100/6 = 50/3 = $16.67

27. Long Run Demand for Money (LRMD)MS
Value of Money
1/PL
LRMD QM
Quantity of Money

28. As the value of money falls, price levels rise, causing inflation

29. The LR Effect of a Change in the Quantity of Money
Fed increases the money supply
Nominal interest rates fall
People want to borrow and spend more money
Because real GDP = potential GDP, production is constant and people can’t buy more
This causes price levels to rise
The value of money decreases
A new long-run equilibrium is established with a price level increase that’s proportional to the increase in the money supply

30. When MS increases, what happens to the PL? What does this result in?
Value of Money
1/PL1
1/PL2
LRMD QM
Quantity of Money

31. The Babysitting Coop
Listen to the Planet Money podcast “Trouble Inside a Babysitting Economy”
Start: 0:00
End: 8:50
Reflection Questions:
What created the shortage of “money?”
What did the coop organizers do to promote people to spend their babysitting tokens?
What happened to the value of the currency?

32. The Velocity of Circulation
The average number of times in a year that each dollar of money gets used to buy final goods and services.

33. Example of the Velocity of Circulation
GDP Price Index = 125
Real GDP = ϒ = $8 trillion
M = $2 trillion
V = (1.25 * 8) / 2 = 1.25 * 4 = 5
V = 5 means that each dollar in circulation, on average, gets used about 5 times
ϒ = upsilon

34. Velocity of Circulation for M1 in US
*Graph downloaded from Federal Reserve Economic Data (FRED) website
What does the velocity of circulation reveal about the state of the economy?

35. Equation of Exchange
Equation of Exchange: an equation that states that the quantity of money multiplied by the velocity of circulation equals the price level multiplied by real GDP
MV = Pϒ
M = quantity of money supplied
V = velocity of circulation
P = price level
ϒ = real GDP

36. The Quantity Theory of Money
The proposition that when real GDP equals potential GDP and the velocity of circulation is constant, an increase in the quantity of money brings an EQUAL percentage increase in the price level. MV = Pϒ

37. Why do we care about V?
Knowing V allows us to determine how many goods and services were purchased
Example: V = 5, QM = $2 trillion
$10 trillion of goods and services were purchased

38. Federal Reserve Economic Data (FRED)
Run by the Fed of St. Louis

39. QM and Inflation
When QM growth rate increases, inflation rate increases
When QM growth rate decreases, inflation rate decreases

40. Hyperinflation
When the inflation rate exceeds 50% a month (12,875% per year)
Occurs when the quantity of money grows at a rapid pace
Often a result of government expenditures being much greater than tax revenue, causing the government to print more money
Causes the population to minimize their holdings of local money
Ex. Zimbabwe in 2008, inflation rate = 231,150,888.87% per year

41. Instances of Hyperinflation
Take a look at the 55 instances of hyperinflation throughout the world.
If a Big Mac costs $3.99 today, how much would it cost at the end of a year if the US was currently experiencing hyperinflation at the same rate as…
Hungary in 1945 (Table 1)
Brazil in 1989 (Table 2)
Zimbabwe in 2007 (Table 3)

42. How Four Drinking Buddies Saved Brazil

43. Sample AP Problem
The required reserve ratio is 0.2 and the Federal Reserve sells $1 million in securities. If there are no leakages and banks do not hold excess reserves, then what is the change in the money supply?
A decrease of $5 million

44. Sample AP Problem
The Federal Reserve can cause an increase in interest rates in an attempt to…
Reduce inflation
Reduce cyclical unemployment
Reduce structural unemployment
Increase aggregate demand
Increase investment spending
Support your answer with a graph. A

45. Sample AP Problem
If the velocity of money is stable, the quantity theory of money predicts that an increase in the money supply will lead to a proportional…
Increase in the nominal output
Decrease in the price level
Decrease in the nominal interest rate
Decrease in the real interest rate
Decrease in the unemployment rate A

46. Sample AP Problem
Which of the following is most likely to occur when the Federal Reserve buys government bonds on the open market?
The demand for money will decrease
The government’s debt will decrease
Interest rates will decrease
The discount rate will increase
Investment demand will decrease C

47. Sample AP Problem
Which of the following actions by the Federal Reserve reduces the ability of the banking system to create money?
Decreasing the federal funds rate
Decreasing the discount rate
Increasing the money supply
Increasing the reserve requirement
Buying government bonds on the open market D

48. Sample AP Problem
Which of the following government policies can reduce the rate of inflation in the short run?
Providing investment tax credits for businesses
Reducing personal income tax rates
Selling bonds on the open market
Decreasing the reserve requirement
Decreasing the discount rate C

49. Sample AP Problem
Which of the following is true of the quantity of money demanded?
It rises when interest rates rise, because the return from holding money increasing
It falls when interest rates rise, because the opportunity cost of holding money increases
It remains constant when interest rates rise, as long as inflation remains constant
It rises when interest rates rise, as long as inflation is declining
It falls when the money supply increases, as long as inflation remains constant B

50. Sample AP Problem
Expansionary monetary policy can affect the economy through which of the following chains of events?
Increasing he discount rate lowers the real interest rate, which raises investment
Reducing taxes lowers the discount rate, which raises consumption
Increasing government expenditure lowers the interest rate, which raises investment
Increasing the reserve requirement decreases the interest rate, which increases investment
Buying bonds increases the money supply, which lowers the interest rate E

51. Sample AP Problem – Money Markets
A drop in credit card fees causes people to use credit cards more often for transactions and demand less money.
Using a correctly labeled graph of the money market, show how the nominal interest rate will be affected.
Given the interest rate change in part (a), what will happen to bond prices in the short run?
Given the interest rate change in part (a), what will happen to the price level in the short run? Explain.
Identify an open-market operation the Federal Reserve could use to keep the nominal interest rate constant at the level that existed before the drop in credit card fees. Explain.

52. Sample AP Problem – Money Market and Loanable Funds Market
Interest rates are important in explaining economic activity.
Using a correctly labeled graph of the money market, show how an increase in the income level will affect the nominal interest rate in the short run.
Using a correctly labeled graph of the loanable funds market, show how a decision by households to increase saving for retirement will affect the real market interest rate in the short run.
Suppose that the nominal interest rate has been 6 percent with no expected inflation. If inflation is now expected to be 2 percent, determine the value of each of the following.
The new nominal interest rate
The new real interest rate