Macro Module 9

Market for Money

The opportunity cost of money, or the interest rate, is the basis of the market for money. The market for money is where the demand for money and the supply of money interact to determine the equilibrium interest rate. The quantity of money circulating in an economy depends on the interest rate.

Inflation

An increase in the quantity of money results in a lower nominal interest rate. In the long run, however, the nominal interest rate will return to its original value because the value of money is falling. To say that the value of money is decreasing means the price level is rising. A rise in the price level is inflation. With all other factors constant over time, a given percentage increase in the quantity of money brings an equal percentage increase in the price level. This is to say, inflation is a monetary phenomenon.

The quantity of money multiplied by the velocity of circulation equals the price level multiplied by real GDP.

Equation of Exchange

According to the equation of exchange, if the velocity of circulation is 2 and the quantity of money is $4 billion, nominal GDP is $2 billion.

False

Wealth

Households and businesses don't keep all their wealth in cash. Wealth is held in many different forms, including real assets like land and equipment, along with financial assets, like stocks, bonds, and mutual funds. Some wealth is kept as cash in the form of currency or deposits at the bank.

Inflation is always and everywhere a monetary phenomenon.

Milton Freidman

When real GDP equals potential GDP, an increase in the quantity of money brings an equal percentage increase in the price level.

Quantity Theory of Money

According to the quantity theory of money, the inflation rate would be 0% if the real GDP grows by 2%, the velocity of circulation remains constant, and the quantity of money grows by 2%.

True

Inflation increases the after-tax return on saving.

False

Quantity of Money

The quantity of money supplied is fixed unless the Fed decides to change its policies.

Impact on Banks

Banks also find it harder to lend out money if they are uncertain about future inflation. Suppose you want to take out a student loan in the amount of $10,000 with a 7% nominal interest rate for 10 years. The real value of this loan and the profits the bank will ultimately make on it depend on inflation. If the economy experiences hyperinflation over this 10 year period, wages and prices will both rise and you will be able to pay back the loan easily. The bank will lose out. Even if inflation is just a little above 7% the bank loses on the loan. Inflation is hard to predict and imposes risks on the bank that can discourage lending.

An increase in real GDP leads to a leftward shift in the demand for money curve.

False

The value of money is determined by the Federal Reserve.

False

The uncertainty costs of inflation lead to an increase in investment.

Fase

Price Level

First, changes in the overall price level will change the quantity of money that households and businesses want to hold. The quantity of money demanded is proportional to the price level. For example, when the price level doubles, the quantity of dollars demanded doubles. A rise in the price level leads to a rightward shift in the demand for money curve.

Observation 1

First, real GDP equals potential GDP at full employment, and potential GDP is determined by only real factors and not the quantity of money. Potential GDP is not dependent on nominal factors, but on real factors like physical capital and labor productivity.

Impact on Citizens

High inflation is correlated with increased uncertainty about the inflation rate. When prices are rising rapidly, it is difficult to assess the expected profit on an investment. This increased uncertainty leads people to spend more time predicting inflation, or hedging against it with commodities like gold, and less time at productive activities. In other words, when people worry about inflation, they invest less in new businesses or new skills. When households hoard assets or spend too much time trying to estimate future inflation rates, less money in savings is moved to investments in productive assets. The decline in capital formation slows the economic growth rate.

Opportunity Cost

However, there is a drawback to simply holding cash, called the opportunity cost. Cash can be invested to earn interest. The interest rate is what someone gives up in order to hold onto cash. If interest rates rise, the opportunity cost of holding cash rises. In the face of rising interest rates, households and businesses will hold less of their wealth in cash.

The Fed influences this market by changing the quantity of money in the economy. In doing so, the Fed is able to influence the interest rate and overall economic activity.

If the Fed decreases the quantity of money supplied by selling government securities in an open market operation, the equilibrium interest rate rises. If the Fed increases the quantity of money, the interest rate falls.

Real Interest Rate

In the long run, the nominal interest rate equals the equilibrium real interest rate plus the inflation rate. In other words, the real interest rate earned from an investment is the nominal interest rate paid minus the inflation rate for that time period. The real interest rate is independent of the price level.

Review

Individuals dislike inflation because as prices rise, they have less buying power. Individuals have to spend more time searching for lower prices, and they may have to pay higher taxes on investments. Banks will be reluctant to lend money they know will not keep its value to create a profit. Inflation can cause confusion for consumers, businesses, and the government.

Section REVIEW

People who hold on to money in the form of cash are subject to an opportunity cost in the form of the interest they lose by not investing. The amount of cash people hold onto depends on the nominal interest rate. If the rate rises, the quantity of money demanded drops, and if the rate drops, the quantity of money demanded rises. The demand for money is the relationship between the quantity of money demanded and the nominal interest rate.

Real GDP

Second, changes in real GDP lead to changes in the quantity of money that households and businesses want to hold. An increase in income leads to more demand for goods and services. An increase in real GDP increases the quantity of money people plan to hold so that they can make the increased expenditures. A rise in real GDP leads to a rightward shift in the demand for money curve.

Shoe Leather Costs

Shoe-leather costs are incurred when people have to quickly exchange cash for goods to beat rapidly rising prices. High inflation generates transaction costs as individuals try to avoid losses from the falling value of money. In the summer of 2008, the annual rate of price growth in Zimbabwe reached as high as 11,200,000%. In countries with this kind of hyperinflation, wage payments are made frequently—sometimes multiple times a day. Workers then spend their wages as quickly as possible before the money loses any more of its value. All this time going to the store is called a shoe-leather cost because individuals wear out their shoes as they rush around converting money to goods and services.

Tax Effects

Tax costs result when inflation reduces the net return on investments. Because inflation increases the nominal interest rate and the income from the nominal interest rate is taxed, higher inflation reduces the after-tax real interest rate. Therefore, higher inflation rates reduce the incentive to invest.

Terms Describing Immediate Costs of Inflaton

Tax effects Shoe-leather costs Confusion

Nominal Interest Rates

The Fed does not have to change policies in response to a change in nominal interest rates. Graphically, the supply of money curve is perfectly vertical.

Nominal Interest Rate

The dollar amount of interest expressed as a percentage of the amount loaned. The quantity of money that people and businesses hold depends on the nominal interest rate. An increase in the nominal interest rate decreases the quantity of real money demanded. A decrease in the nominal interest rate raises the quantity of real money demanded.

In the market for money, the intersection is found where the supply of money, which is fixed by the Fed, meets the demand for money from households and businesses.

The equilibrium interest rate equates the quantity of real money demanded with the fixed quantity of real money supplied.

Nominal Interest Rate

The nominal interest is what people earn when they invest their wealth in real assets like land and equipment, or financial assets such as stocks and bonds, instead of holding on to their cash. The interest rate received must compensate the investor for not only being without his or her cash for some period of time, but for also losing some purchasing power because of inflation.

Topic Two Review

The quantity of money demanded rises with the price level and will rise if more is needed to make purchases. An increase in the quantity of money results in a lower nominal interest rate. In the long run, however, the nominal interest rate will return to its original value because the value of money is dropping. When the value of money is decreasing, it means that the price level is rising, and inflation represents a rise in the price level.

Equation of Exchange

The quantity theory of money begins with an identity called the equation of exchange, which is stated in equation form as M x V = P x Y. The equation of exchange states that the quantity of money, M, multiplied by the velocity of circulation, V, equals the price level multiplied by real GDP. Nominal GDP equals real GDP, Y, multiplied by the price level, P, or nominal GDP = P × Y. The velocity of circulation, V, is the number of times in a year that the average dollar of money gets used to buy final goods and services. The equation of exchange is an absolute definition, which means that it is always true. The quantity theory of money adds two observations to this equation.

Qunatity Theory of Money

The quantity theory of money is a theoretical model used to explain the long-run relationship between the quantity of money and inflation. This proposition says that when real GDP equals potential GDP, an increase in the quantity of money brings an equal percentage increase in the price level. Let's examine the process that explains 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.

Observation 2

The second observation is that the velocity of circulation does not change when the quantity of money changes. This is to say that frequency at which money circulates through the economy is not dependent on the quantity of money. Given that velocity and potential GDP are not influenced by the quantity of money, a percentage change in M results in the same percentage change in P, the price level. For example, a 10% increase in the money supply will increase the price level by 10%.

Financial Technology

Third, new financial technologies can change the demand for money. Some financial innovations decrease the quantity of money people plan to hold. For example, when more merchants accept credit cards, more households will use them and not keep as much money in checking accounts each month. This leads to a decrease in the demand for money. Other financial innovations increase the demand for money. For example, when more banks pay interest on checking accounts, more people keep their wealth in these accounts.

A change in the nominal interest rate changes the quantity of money demanded, meaning there is a movement along the money demand line. A change in any factor other than the nominal interest rate will change the demand for money.

This results in a shift of the demand curve. The following are the factors that affect the demand for money.

In the long run, when the Fed increases the money supply, the price level rises.

True

The opportunity cost of holding money is the foregone interest you could have earned on an alternative asset.

True

Value of Money

We can conclude from this that changes in the nominal interest rate alone cannot maintain equilibrium in the money market in the long run. Something else must change. This is the value of money. The value of anything is normally measured by its price in money terms. What then is the price of money? To answer this question, we reverse the previous statement and say that the price of money is the value of money. This means that the value of money is the quantity of goods and services that a unit of money will buy. If you go to McDonalds and purchase a McDouble for $1, we can say the price of $1 is one McDouble. In other words, the value of one dollar is one McDouble. In general, the value of money is the total quantity of all the goods and services that money can buy. This is the inverse of the price level.

we can say that the inflation rate growth = money growth + velocity growth - real GDP growth.

We can conclude from this that in the long run, the percentage increase in the price level, or inflation rate, equals the percentage increase in the quantity of money plus the percentage increase in velocity minus the percentage increase in real GDP.

Confusion

When prices are rising, it is also hard for shoppers to comparison shop or for businesses to know how competitive their prices may be. Confusion costs are the difficulties that arise when prices are changing so quickly that is hard to compare marginal benefits to marginal costs. During periods of inflation, firms must change their prices more often. Furthermore, when inflation distorts relative prices, consumer decisions are unclear, and markets are less able to allocate resources to their best use