Chapter 12- Money, Interest, and Inflation

Changes in the Demand for Money

1) The Price Level 2) Real GDP 3) Financial Technology

"Price" of Money

1) The value of money 2) The opportunity cost of holding money *Measured by the marginal benefit of holding an additional dollar

Nominal Interest Rate

1) When nominal interest rate is below equilibrium, the quantity of money demanded will increase - Interest rates will rise 2) When nominal interest rate is above equilibrium, the quantity of money demanded will decrease - Interest rates will fall 3) Nominal interest rate is inversely proportional to bond price 4) The equilibrium is determined by the loanable funds market

Changes in Inflation

1) When the money growth rate increases: - Inflation rate increases slowly - Temporary increase in Real GDP growth rate - Velocity increases while inflation speeds up, then stabilizes *Faster inflation reduces potential GDP, slows down real GDP growth, and velocity growth returns to normal (∆M = ∆P) 2) When the money growth rate decreases: - Opposite effects *In the long run and other things remaining the same, a change in the growth rate of the quantity of money brings an equal change in the inflation rate

Price Level (P) Calculation

GDP Price index divided by 100 Therefore, value of money = 1/ x/100 = 100/x

Price Level

The demand for money is proportional to the price level *Increased price level means we need more money to make payments; will increase quantity demanded by same %

Tax Costs

The government gets revenue from inflation because inflation is a tax; when the government spends newly created money, the quantity of money increases (inflation rate increases by the same percentage); the decreased value of money is what is lost to the government

Opportunity Cost of Holding Money

The interest rate forgone on an alternative asset *The higher the interest income forgone by not holding other assets, the smaller is the quantity of money demanded (people look for substitutes) The Nominal Interest Rate is the Real Cost (because inflation would also be subtracted from the $ you hold)

The Quantity Theory of Money

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 *Uses the velocity of circulation and the equation of exchange

The Value of Money

The quantity of goods and services that a unit of money will buy *The inverse of the Price Level (P) Value of Money =1/P -- use this instead of percentage -- As the value of money increases, the quantity of money demanded decreases by the same percent (can buy more) Money market equilibrium occurs when the value of money is 1 In the long run, money market equilibrium determines the value of money and the price level

Demand for Money

The relationship between the quantity of money demanded and the nominal interest rate, when all other influences on the amount of money that people wish to hold remain the same (shown on a schedule or a curve)

Supply of Money

The relationship between the quantity of money supplied and the nominal interest rate (vertical line) *On a given day, the price level, real GDP, and the state of financial technology are fixed; the interest rate is free to fluctuate

Shoe-Leather Costs

When money loses value at a rapid rate, it does not function well as a store of value; people try to avoid holding money, so they spend incomes and pay wages as soon as they get the money to do so (i.e. Brazil, Germany, Israel)

Financial Technology

1) Daily interest checking deposits, automatic transfers between checking and savings deposits, automatic teller machines, debit cards, and smart cards have increased the marginal benefit of holding money, and have increased the demand for money 2) Credit cards have decreased the demand for money *More credit cards now than in 1970, less than in 2007

Immediate Effects of the Fed's Actions

1) If the Fed increases the quantity of money, short-term nominal interests rates fall 2) If the Fed decreases the quantity of money, short-term nominal interest rates rise

Long-Run Effects of the Fed's Actions

1) If the Fed increases the quantity of money, the price level rises 2) If the Fed decreases the quantity of money, the price level falls 3) If the Fed speeds up the rate at which the quantity of money grows, the inflation rate increases 4) If the Fed slows down the rate at which the quantity of money grows, the inflation rate decreases

Effects of the Income Tax

1) Income taxes increase the before-tax interest rate, which decreases borrowing and investment 2) Income taxes decrease the after-tax interest rate, which decreases lending and saving *An increase in the inflation rate enhances these effects - Income tax takes X% out of the before-tax interest rate - If inflation rises, and the nominal interest rate rises, inflation is subtracted from the after-tax interest rate

Costs of Inflation

1) Tax Costs 2) Shoe-Leather Costs 3) Confusion Costs 4) Uncertainty Costs *Inflation is caused when the quantity of money continually grows faster than the real GDP

Changing the Interest Rate

1) The Fed will increase the quantity of money to cause interest rates to fall 2) The Fed will decrease the quantity of money to cause interest rates to rise

Long-Run

Real GDP equals potential GDP on average

Quantity of Money Supplied

Determined by the actions of banking systems and the Fed; it is fixed on any given day

Law of Changes in the Quantity of Money

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 (and an equal/opposite percentage change in the value of money) *If the Fed increases the quantity of money, people are holding too much money, so they buy bonds and the interest rate falls; if the Fed decreases the quantity of money, people are holding too little money, so they sell bonds and the interest rate rises - If the growth rate of the quantity of money increases, the supply curve shifts to the right (interest rates decrease)

Confusion Costs

Marginal Benefits and Marginal Costs continue to change because the value of money is fluctuating, so borrowers/lenders and workers/employers cannot make agreements (may/may not be a large issue)

Inflation in the Quantity Theory of Money

Money growth rate + Velocity growth rate = Inflation rate + Real GDP growth rate (change in values from Equation of Exchange) Inflation rate = money growth + velocity growth - Real GDP growth

Creating New Money

Not printing; when the central bank buys government bonds in open market operations, the monetary base increases (and the quantity of money increases proportional to the money multiplier)- the fed pays its profits to the government so the government pays no interest on the bonds

Law of Demand (for Money)

Other things remaining the same, the higher the nominal interest rate, the smaller is the quantity of money demanded

Uncertainty Costs

People become uncertain about long-term inflation, so investment falls and economic growth slows; additionally, resources are misallocated as people trained in other professions begin to find it more profitable to dabble in economics and profit off of inflation

Actual Cost of Inflation

Peter Howitt of Brown University estimated that if inflation is lowered from 3% per year to 0% then the growth rate of Real GDP will rise by between 0.06 and 0.09 % per year (85% of current after 30 years) *After 30 years the GDP would be 2.3% higher

The Quantity Theory Prediction

Rearranged the Equation of Exchange by dividing both sides by Real GDP P = (M x V) ÷ Y 1) At full employment, real GDP equals potential GDP, which is determined only by real factors and not by the quantity of money 2) The velocity of circulation is relatively stable and does not change when the quantity of money changes *Treat V and Y as constants, percentage increase in P equals the percentage increase in M

The Equation of Exchange

States that the quantity of money (M) multiplied by the velocity of circulation (V) equals the price level (P) multiplied by the real GDP (Y) M x V = P x Y *Decade average fluctuations in the velocity of circulation and the real GDP are small

Quantity of Money Demanded

The amount of money that households and firms choose to hold

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 Nominal GDP = Real GDP (Y) * The Price Level (P) Velocity of Circulation is V, quantity of money is M V = (P x Y) ÷ M

Real GDP

The demand for money is proportional to the Real GDP *To make increased expenditure and income payments, we need more money Growth Rate of Nominal GDP = Growth Rate of Real GDP + Inflation Rate

Hyperinflation

When the inflation rate exceeds 50% per month (12,875% per year) - Highest rate was Zimbabwe at 231,150,888.87% per year in July 2008 (about 500% per month) - Also Germany in the 1920s (1921, 1922, 1923) -Pg. 312 - Brazil, Israel, Russia, etc. *Fed can usually keep inflation around 2% per year