1. Lecture 18: Inflation and Money Growth I L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.11 4 March 2010

2. Introduction Last time: – Used model of money demand to examine how price level changes with GDP – Found prices counter-cyclical – Price-targeting could be used to stabilise P Today – Reconsider these findings in a dynamic model (i.e. multi-periods) and implications for inflation.

3. Inflation in the Model Inflation is continual rise in prices: how could it be explained in our model – By consistently falling demand (due to lower output) – By consistent increases in financial innovation – Both of these are improbable – By consistently increasing money supply (much more likely)

4. Understanding Inflation Marked cross-sectional variation in inflation rates across countries – 80% per year in Congo – 3% in Germany Cross-country inflation rates closely correlate with rate of growth of money supply – Suggests we should look to a money supply-based explanation

5. Inflation Algebra Inflation rate between yr 1 and 2 denoted ‘π’ Inflation rate between yr 1 and yr2 = (price in year 2 – price in year 1) / price in year 1 Inflation rate between yr 1 and yr2 = ‘delta p1’ / price in year 1 Price in year 2 = (1 + inflation rate between yr1 and yr2) x price in year 1

6. Real and Nominal Interest Rates With inflation, need distinction between real and nominal interest rates: – Nominal interest rate: money return on bonds – Real interest rate: real return on bonds – E.g. i is 5%, π is 3%. £100 earns £5 nominal interest, but adjusted for inflation, return is £2 Real interest rate = nominal interest rate – inflation rate

7. Actual and Expected Real Interest Rates Individuals make decisions on the basis of real interest rates – What is the return / cost of lending / borrowing in real terms – What is the real return to working today? – High nominal interest rates do not mean high real returns if inflation is also high – Crucial for intertemporal choice over consumption / saving and labour supply

8. Expected Real Interest Rate Choices made on the basis of an expected inflation rate – Nominal interest rate is known – Inflation rate (future variables) has to be predicted Expected real interest rate = nominal interest rate – expected inflation rate

9. MID-TERM EXAM PREP