Money and Inflation

By
Diljite Arra
D-74
MNM B-School
 Introduction

• In this section we will discuss the quantity theory of money,

discuss inflation and interest rates, and the relationship
between the nominal interest rate and the demand for money.
 The Quantity Equation

• This model allows us to see the effect that the quantity of

money has on the economy.
• To do this we must see how the quantity of money is
related to price and incomes.
 The Quantity Equation
Consumers need money to purchase
goods and services. The quantity of
money is related to the number of Money•Velocity = Price•Transactions
pounds exchanged in transactions. The
link between transactions and money is
expressed in the quantity equation.
M V  P  T
On the left hand side, “M” is the
On the right hand side, “T” is
quantity of money, “V” is the
the total number of transactions
velocity of money, and “V•M” is
during some period of time, “P”
essentially a measure of how the
is the price of a typical
money is used to make
transaction, and “P•T” is the
transactions.
number of pounds exchanged in
Rearranging the quantity equation a year.
yields velocity to be…
V  PT / M
Economists usually use GDP “Y” as a
proxy for “T” since data on the number
of transactions is difficult to obtain. M V  P  Y
The Money Demand Function and the Quantity Equation

It is often useful to express the quantity of

money in terms of the quantity of good and
services it can buy. This is called the real
money balances “M/P”. We can use this
to construct a money demand function.

( M / P)  kY
d

“k” is a constant that tells us how This equation states that the
much money people want to hold quantity of real money balances
for every unit of income. demanded is proportional to real
income.
The Money Demand Function and the Quantity Equation

( M / P)  kY
d

The money demand function offers

another way to view the quantity
( M / P )  kY
equation. If we set money supply
equal to money demand we get…

A simple rearrangement of terms M (1/ k )  PY

changes this equation into…

Which can be written as… MV  PY

Where V=1/k

This shows the link between money

demand and the velocity of money.
Assuming Constant Velocity and the Quantity Theory of
Money

The quantity equation is essentially a

definition. If we make the assumption MV  PY
that the velocity of money is constant,
then the quantity equation becomes a
theory of the effects of money, called
the quantity theory of money.

Because velocity is fixed, a change in

the quantity of money (M) must cause
a proportionate change in nominal
GDP (PY). So the quantity of money
determines the money value of the
economy’s output.
 Money, Prices, and Inflation

The quantity theory of money allows

us to explain the overall level of prices. MV  PY

The production function determines

the level of output “Y”.
Y
The money supply determines the
nominal value of output, “PY”. PY
So, productive
The price level “P” is the
PY capacity determines
ratio of the nominal value
of output “PY” to the level P real GDP
of output “Y”. Y (numerator) and the
quantity of money
determines nominal
So if the money supply GDP (denominator).
increases, nominal GDP will
rise as well the price level.
 Money, Prices, and Inflation

This change in prices is inflation. The

PY
inflation rate is the percent change in
price level. So this theory of price P
level is also a theory of inflation rate. Y
We can write the quantity equation… MV  PY
…in percent terms:
%M + %V = %P + %Y
“M” is “%ΔY” depends on
controlled by the growth in the factors
central bank. of production and
on technological
“%ΔV” reflects shifts in “%ΔP” is the
progress (we
money demand (which rate of inflation.
assume this is fixed
are assumed constant). in the short run).
 Money, Prices, and Inflation

• So, the quantity theory of money states that the central bank,
which controls the money supply, has ultimate control over the
rate of inflation.
• If the central bank keeps the money supply stable, the price
level will be stable. If the central bank increases the money
supply rapidly, the price level will rise rapidly.
 Inflation and the Interest Rate

Economists call the interest rate that the

r  i 
bank pays the nominal interest rate “i”
and the increase in consumer purchasing
power the real interest rate “r”. If we let
“π” represent the inflation rate the
relationship among these variables is…

i  r 
So, the real interest rate is the difference
between the nominal interest rate and the
rate of inflation.

Rearranging and solving for the nominal

interest rate yields the Fisher equation.
The Fisher equation states that the
nominal interest rate can be affected by
either the real interest rate or inflation.
 Inflation and the Interest Rate

Recall that according to the quantity

theory of money a 1% increase in money
growth implies a 1% increase in the rate i  r 
of inflation. According to the Fisher
equation a 1% increase in inflation implies
a 1% increase in the nominal interest rate.
i1%  r   1%
This one-to-one relationship between the
inflation rate and the nominal interest rate
is called the Fisher effect. %  %i
When borrowers and lenders agree on a nominal
interest rate they do not know what the inflation r  i  e

rate will be. Let “π” denote the actual future

r  i 
inflation and “πe” the expectation of future inflation.
This gives us the ex ante real interest rate…

We call our original formula for real interest

rate the ex post real interest rate.
 Two Real Interest Rates: Ex Ante and Ex Post

• The two real interest rates

differ when actual inflation
differs from expected inflation.
i  r  e
• This changes our fisher
equation. The nominal interest
rate now depends on expected
future inflation.
• So the nominal interest rate r
moves one-for-one with the S
expected inflation rate.
• The real interest rate is
determined by equilibrium in
the market for goods and
services. r*
I(r)

S,I
The Nominal Interest Rate and the Demand for Money

• Earlier we used the quantity theory of money to explain the

effects of money on the economy. Now we will add the
nominal interest rate as another determinant of the quantity
of money demanded.
By holding money consumers are foregoing
the real return “r” that could be had by
holding other assets such as government
bonds.

r  e
i
The fisher equation
tells us this is equal
to the nominal
interest rate.

Additionally, money
earns an expected The total cost of
real return of… holding money is…
The Nominal Interest Rate and the Demand for Money

r  e
i
As income “Y” rises the demand for money
rises and as the interest rate rises the
demand for money falls.

Our augmented money demand 

function includes this nominal interest ( M / P )  L(i, Y )
d
rate in addition to income. Where “L”
is the liquidity of real money balances.

Or
( M / P )  L(r   , Y )
d e
 Future Money and Current Prices

• Money, prices, and interest rates are now

related.
• The quantity theory of money explains that
money supply and money demand
determine price.
• By definition changes in price are inflation
• Inflation affects the nominal interest rate
via the fisher effect. i  r  e

• And the nominal interest rate affects money

demand. ( M / P) d  L(i, Y )
Money
Supply

Nominal
Price Inflation
Interest
Level Rate
Rate

Money
Demand
 Conclusions

• In this section we introduced the quantity theory of money

and the relationship between money supply and inflation. Via
the fisher effect we learned that inflation affects the nominal
interest rate and finally, that the nominal interest rate affects
the demand for money.