

Macroeconomics
ECO 403
VU
LESSON
12
MONEY AND
INFLATION (Continued...)
The
Fisher Effect
·
The
Fisher equation:
i=r+š
S = I determines
r.
Hence, an
increase in š
causes
an equal increase in i.
This
oneforone relationship
is
called the Fisher
effect.
Exercise:
Suppose
V is constant, M is growing 5% per
year, Y is growing 2% per
year, and r = 4.
·
Solve
for i (the nominal interest
rate).
·
If
SBP increases the money
growth rate by 2 percentage
points per year, find
Δi
.
·
If
the growth rate of Y falls
to 1% per year
·
What
will happen to š?
·
What
must SBP do if it wishes
to
keep
š
constant?
Answers:
First,
find š
= 5  2 = 3.
Then,
find i = r + š
= 4 + 3 =
7.
·
Δi = 2,
same as the increase in the
money growth rate.
·
If
SBP does nothing, Δš
=
1.
To
prevent inflation from
rising, SBP must reduce
the money growth rate by
1
percentage
point per year.
Two
real interest
rates
·
š
=
actual inflation rate
(not
known until after it has
occurred)
·
še
= expected
inflation rate
·
i
še
=
ex ante
real
interest rate:
what
people expect at the time
they buy a bond or take
out a loan
·
i
š = ex post
real interest rate:
what
people actually end up
earning on their bond or
paying on their loan
Money
demand and the nominal
interest rate
·
The
Quantity Theory of Money
assumes that the demand
for real money balances
depends
only
on real income Y.
·
We
now consider another
determinant of money demand:
the nominal interest
rate.
·
The
nominal interest rate i is
the opportunity cost of
holding money (instead of
bonds or
other
interestearning assets).
41
Macroeconomics
ECO 403
VU
·
Hence,
↑i
⇒ ↓
in
money demand.
Linkages
Among Money, Prices and
Interest rate
Money
Supply
Nominal
Price
Inflation
Interest
Level
Rate
Rate
Money
Demand
The
money demand
function
(M
P ) =
L
(i
, Y
)
d
(M/P)
d = real money demand,
depends
·
negatively
on i
i
is the opportunity cost of
holding money
·
positively
on Y
higher
Y ⇒
more
spending so, need more
money
(L
is used for the money
demand function because
money is the most liquid
asset.)
(M
P )d
=
L
(i
,Y
)
=
L
(r
+ š e
, Y
)
When
people are deciding whether
to hold money or bonds, they
don't know what inflation
will
turn
out to be.
Hence,
the nominal interest rate
relevant for money demand is
r + še.
M
Equilibrium
=
L
(r
+ š e
,Y
)
P
Supply
of Real money
balances
Real
money demand
42
Macroeconomics
ECO 403
VU
What
determines what
Variable
how
determined (in the long
run)
M
exogenous
(SBP)
r
adjusts
to make S = I
Y
Y
= F
(K
, L
)
M
P
adjusts
to make
=
L
(i
,Y
)
P
How
P
responds
to ΔM
·
For
given values of r, Y, and še,
a
change in M causes P to change by
the same percentage 
just like in the
Quantity
Theory
of Money.
What
about expected
inflation?
·
Over
the long run, people
don't consistently over or
underforecast inflation, so še
= š
on
average.
·
In
the short run, še
may
change when people get
new information.
EX:
Suppose SBP announces it
will increase M next year.
People will expect
next
year's
P to be higher, so še
rises.
·
This
will affect P now, even
though M hasn't changed
yet.
How
P
responds
to Δše
M
=
L
(r
+ š e
,Y
)
P
·
For
given values of r, Y, and
M,
↑
š e
⇒ ↑ i
(the
Fisher effect)
⇒
↓ (M
P )
d
⇒
↑ P
to make
(M
P ) fall
to
reestablish eq'm
The
social costs of
inflation
...fall
into two categories:
1.
Costs when inflation is
expected
2.
Additional costs when
inflation is
different
than people had
expected.
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