# Macro economics

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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 one-for-one 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?
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 interest-earning assets).
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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
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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
= 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.
·
Over the long run, people don't consistently over- or under-forecast 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 re-establish eq'm
The social costs of inflation
...fall into two categories:
1. Costs when inflation is expected
2. Additional costs when inflation is