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Money, Interest
Rate and Inflation
Chapter 13
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
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.
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
Money and Inflation

Equation of Exchange
– 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)
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 longrun equilibrium level.
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
Effects and Costs of
Inflation

Effects
– 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