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Chapter 7
The Asset Market, Money, and Prices
 Learning Objectives
I. Goals of Chapter 7
A. Define money, discuss its functions, and describe how it is measured in the United States (Sec.
7.1)
B. Discuss the factors that affect how people choose which assets they own (Sec. 7.2)
C. Examine macroeconomic variables that affect the demand for money (Sec. 7.3)
D. Discuss the fundamentals of asset market equilibrium (Sec. 7.4)
D. Discuss the relationship between money growth and inflation (Sec. 7.5)
II. Notes to Eighth Edition Users

A. We modified the section on “The Expected Inflation Rate and the Nominal Interest Rate” and
now call it “The Inflation Rate and the Nominal Interest Rate”
B. We introduce the concept of the break-even inflation rate in discussing expected inflation
©2017 Pearson Education, Inc.

Chapter 7 The Asset Market, Money, and Prices 143
 Teaching Notes
I. What Is Money? (Sec. 7.1)
A. Money: assets that are widely used and accepted as payment
B. The functions of money
1. Medium of exchange
a. Barter is inefficient—it requires a double coincidence of wants
b. Money allows people to trade their labor for money and then use the money to buy goods
and services in separate transactions
c. Money thus permits people to trade with less cost in time and effort
d. Money also allows specialization, since trading is much easier, so people don’t have to
produce their own food, clothing, and shelter
Theoretical Application
There have been a number of attempts to supply detailed microfoundations theory for money. An
explicit theory that shows the superiority of money to barter has been developed by Nobuhiro
Kiyotaki and Randall Wright (“On Money as a Medium of Exchange,” Journal of Political
Economy, August 1989, pp. 927–954). They show how introducing fiat money unambiguously
improves society’s welfare. Much recent research builds on this type of money model.
2. Unit of account
a. Money is the basic unit for measuring economic value
b. This simplifies comparisons of prices, wages, and incomes
c. The unit-of-account function is closely linked with the medium-of-exchange function
d. But countries with very high inflation may use a different unit of account, so they don’t
have to constantly change prices
3. Store of value
a. Money can be used to hold wealth
b. Most people use money only as a store of value for a short period and for small amounts,
because it earns less interest than money in the bank
Money’s usefulness as a store of value declines the higher the inflation rate. In hyperinflations
(very high inflations), people try to avoid the use of money; on receiving their wages, they rush to
buy things before prices rise. And they tend to use currencies other than their own, a phenomenon
known as currency substitution.
4. In touch with data and research: money in a prisoner-of-war camp

a. Radford article on the use of cigarettes as money
b. Cigarette use as money developed because barter was inefficient
c. Even nonsmokers used cigarettes as money
d. Characteristics of cigarettes as money: standardized (so value was easy to ascertain), low
in value (so “change” could be made), portable, fairly sturdy
e. Problem with having commodity money like cigarettes: can’t smoke them and use them
as money at the same time

144 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition
Policy Application
For an introduction to how technological changes affect the role for money in the economy, see
the article by James J. McAndrews, “Making Payments on the Internet,” Federal Reserve Bank
of Philadelphia Business Review, January/February 1997.
C. Measuring money—the monetary aggregates

1. Distinguishing what is money from what isn’t money is sometimes difficult
a. For example, MMMFs allow check writing but give a higher return than bank checking
accounts: Are they money?
b. There’s no single best measure of the money stock
2. The M1 monetary aggregate
a. Consists of currency and traveler’s checks held by the public, and transaction accounts
(which allow the owner to write checks)
b. All components of M1 are used in making payments, so M1 is the closest money measure
to our theoretical description of money
3. The M2 monetary aggregate
a. M2  M1  less money like assets
b. Additional assets in M2 include savings deposits, small (< $100,000) time deposits,
noninstitutional MMMF balances, money-market deposit accounts (MMDAs)
(1) Savings deposits include passbook savings accounts
(2) Time deposits bear interest and have a fixed term (substantial penalty for early
withdrawal)
(3) MMMFs invest in very short-term securities and allow limited check writing
(4) MMDAs are offered by banks as a competitor to MMMFs
4. Table 7.1 shows recent data
Analytical Problem 1 looks at portfolio changes and how they affect M1 and M2
D. In touch with data and research: where have all the dollars gone?
1. In 2015, U.S. currency averaged about $4000 per person
2. Some is held by businesses and the underground economy, but 30% or more is held abroad
3. Foreigners hold dollars because of inflation in their local currency and political instability
4. The data show large fluctuations in M1 when major events occur abroad, for example,
military conflicts
5. The United States benefits from foreign holdings of our currency, since we essentially get an
interest-free loan
E. The money supply
1. Money supply  money stock  amount of money available in the economy
2. How does the central bank of a country increase the money supply?
a. Use newly printed money to buy financial assets from the public—an open-market
purchase
b. To reduce the money supply, sell financial assets to the public to remove money from
circulation—an open-market sale
c. Open-market purchases and sales are called open-market operations
d. Could also buy newly issued government bonds directly from the government (i.e., the
Treasury)

(1) This is the same as the government financing its expenditures directly by printing
money
(2) This happens frequently in some countries (though is forbidden by law in the
United States)
3. Throughout the text, use the variable M to represent money supply; this might be M1, M2, or
some other aggregate
II. Portfolio Allocation and the Demand for Assets (Sec. 7.2)
How do people allocate their wealth among various assets? The portfolio allocation decision
A. Expected return
1. Rate of return  an asset’s increase in value per unit of time
a. Bank account: Rate of return  interest rate
b. Corporate stock: Rate of return  dividend yield  percent increase in stock price
2. Investors want assets with the highest expected return (other things equal)
3. Returns aren’t always known in advance (e.g., stock prices fluctuate unexpectedly), so
people must estimate their expected return
B. Risk
1. Risk is the degree of uncertainty in an asset’s return
2. People don’t like risk, so prefer assets with low risk (other things equal)
3. The risk premium is the amount by which the expected return on a risky asset exceeds the
return on an otherwise comparable safe asset
Their separate work in developing financial theory brought the 1990 Nobel Prize in Economics
to Harry Markowitz, Merton Miller, and William Sharpe. Their main contributions were to
recognize the trade-off between risk and expected return (Markowitz), to develop the Capital
Asset Pricing Model as a general equilibrium theory for pricing assets (Sharpe), and to examine
the corporate financial decision about whether to raise funds via debt or equity (Miller). For an
overview of their research, see Hal Varian, “A Portfolio of Nobel Laureates: Markowitz, Miller,
and Sharpe,” Journal of Economic Perspectives, Winter 1993, pp. 159–169.
C. Liquidity
1. Liquidity is the ease and quickness with which an asset can be traded
2. Money is very liquid
3. Assets like automobiles and houses are very illiquid—it may take a long time and large
transaction costs to trade them
4. Stocks and bonds are fairly liquid, some more so than others
5. Investors prefer liquid assets (other things equal)
D. Time to maturity
1. Time to maturity: the amount of time until a financial security matures and the investor is
repaid the principal
2. Expectations theory of the term structure of interest rates: the idea that investors compare
returns on bonds with differing times to maturity; in equilibrium, holding different types of
bonds over the same period yields the same expected return
3. Because long-term interest rates usually exceed short-term interest rates, a risk premium
exists: the compensation to an investor for bearing the risk of holding a long-term bond
E. Types of assets and their characteristics

1. People hold many different assets, including money, bonds, stocks, houses, and consumer
durable goods
2. Money has a low return, but low risk and high liquidity
3. Bonds have a higher return than money, but have more risk and less liquidity
4. Stocks pay dividends and can have capital gains and losses, and are much more risky than
money
5. Ownership of a small business is very risky and not liquid at all, but may pay a very high
return
6. Housing provides housing services and the potential for capital gains, but is quite illiquid
7. Households must consider what mix of assets they wish to own; text Table 7.2 shows the mix
in 2006, 2009, and 2015. The table illustrates the large declines in the value of stocks,
pension funds, and housing in the financial crisis and shows how the value of stocks and
pension funds rebounded by 2015 to a level substantially higher than it was in 2006, while
the value of housing had almost returned to its 2006 level
F. In touch with data and research: the housing crisis of 2007–2011
1. People gained tremendous wealth in their houses in the 2000s
2. As house prices rose, houses became increasingly unaffordable, leading mortgage lenders to
create subprime loans for people who wouldn’t normally qualify to buy houses
3. Most subprime loans had adjustable interest rates, with a low initial interest rate that would
later rise in a process known as mortgage reset
4. As long as housing prices kept rising, both lenders and borrowers thought the subprime loans
would work out, as the borrowers could always sell their houses to pay off the loans
5. But housing prices stopped rising as much, leading more subprime borrowers to default, so
banks began to tighten their lending standards, reducing the demand for housing and leading
housing prices to start falling (text Figure 7.1)
6. Many homeowners lost their homes and financial institutions lost hundreds of billions of
dollars because of mortgage loan defaults
7. Because many mortgage loans had been securitized and were parts of mortgage-backed
securities, the increased default rate on mortgages led to a financial crisis in Fall 2008, as
many investors simultaneously tried to sell risky assets, including mortgage-backed
securities and stocks
Data Application
Was the housing crisis caused by insiders trying to capitalize on foolish homeowners or a failure by
bank regulators? According to Christopher L. Foote, Kristopher S. Gerardi, and Paul S. Willen, in
their paper “Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the
Foreclosure Crisis,” Federal Reserve Bank of Boston Public Policy Discussion Paper 12-2, May
2012, many people made bad decisions in an atmosphere that appeared to be a bubble in housing
prices. Given views about future housing prices that turned out to be too optimistic, homeowners,
lenders, and investors all made bad decisions.
G. Asset demands
1. Trade-off among expected return, risk, liquidity, and time to maturity
2. Assets with low risk and high liquidity, such as checking accounts, have low expected
returns
3. Investors consider diversification: spreading out investments in different assets to reduce risk

4. The amount a wealth holder wants of an asset is his or her demand for that asset
5. The sum of asset demands equals total wealth
III. The Demand for Money (Sec. 7.3)

A. The demand for money is the quantity of monetary assets people want to hold in their portfolios
1. Money demand depends on expected return, risk, and liquidity
2. Money is the most liquid asset
3. Money pays a low return
4. People’s money-holding decisions depend on how much they value liquidity against the low
return on money
B. Key macroeconomic variables that affect money demand
1. Price level
a. The higher the price level, the more money you need for transactions
b. Prices are 10 times as high today as 65 years ago, so it takes 10 times as much money for
equivalent transactions
c. Nominal money demand is thus proportional to the price level
2. Real income
a. The more transactions you conduct, the more money you need
b. Real income is a prime determinant of the number of transactions you conduct
c. So money demand rises as real income rises
d. But money demand isn’t proportional to real income, since higher-income individuals use
money more efficiently, and since a country’s financial sophistication grows as its income
rises (use of credit and more sophisticated assets)
e. Result: Money demand rises less than 1-to-1 with a rise in real income
3. Interest rates
a. An increase in the interest rate or return on nonmonetary assets decreases the demand for
money
b. An increase in the interest rate on money increases money demand
c. This occurs as people trade off liquidity for return
d. Though there are many nonmonetary assets with many different interest rates, because
they often move together we assume that for nonmonetary assets there’s just one nominal
interest rate, i
e. The real interest rate, which affects saving and investment decisions, is r  i  e
f. The nominal interest paid on money is im
C. The money demand function
1. Md  P  L(Y, i) (7.1)
a. Md is nominal money demand (aggregate)
b. P is the price level
c. L is the money demand function
d. Y is real income or output
e. i is the nominal interest rate on nonmonetary assets
2. As discussed above, nominal money demand is proportional to the price level
3. A rise in Y increases money demand; a rise in i reduces money demand
4. We exclude im from Eq. (7.1) since it doesn’t vary much
5. Alternative expression:
Md  P  L(Y, r  e) (7.2)
A rise in r or  reduces money demand
e
6. Alternative expression:

Md/P  L(Y, r  e) (7.3)

7. The left side of Eq. (7.3) is the demand for real balances, or real money demand
D. Other factors affecting money demand
1. Wealth: A rise in wealth may increase money demand, but not by much
2. Risk
a. Increased riskiness in the economy may increase money demand
b. Times of erratic inflation bring increased risk to money, so money demand declines
3. Liquidity of alternative assets: Deregulation, competition, and innovation have given other
assets more liquidity, reducing the demand for money
4. Payment technologies: Credit cards, ATMs, and other financial innovations reduce money
demand
E. Elasticities of money demand
1. How strong are the various effects on money demand?
2. Statistical studies on the money demand function show results in elasticities
3. Elasticity: The percent change in money demand caused by a one percent change in some
factor
4. Income elasticity of money demand
a. Positive: Higher income increases money demand
b. Less than one: Higher income increases money demand less than proportionately
c. Goldfeld’s results: income elasticity  2/3
5. Interest elasticity of money demand
Small and negative: Higher interest rate on nonmonetary assets reduces money demand
slightly
6. Price elasticity of money demand is unitary, so money demand is proportional to the price
level
F. Velocity and the quantity theory of money
1. Velocity (V) measures how much money “turns over” each period
2. V  nominal GDP/nominal money stock  PY/M (7.4)
Numerical Problem 1 is an empirical exercise calculating velocity from a money-demand

equation.
3. Plot of velocities for M1 and M2 (text Figure 7.2) shows fairly stable velocity for M2, erratic
velocity for M1 beginning in early 1980s
4. Plot of money growth (text Figure 7.3) shows that instability in velocity translates into erratic
movements in money growth
Analytical Problem 2 asks for explanations for the upward trend in M1 velocity prior to
the 1980s.
5. Quantity theory of money: Real money demand is proportional to real income

a. If so,
Md/P  kY (7.5)
b. Assumes constant velocity, where velocity isn’t affected by income or interest rates

c. But velocity of M1 is not constant; it rose steadily from 1960 to 1980 and has been erratic
since then
(1) Part of the change in velocity is due to changes in interest rates in the 1980s
(2) Financial innovations also played a role in velocity’s decline in the early 1980s
d. M2 velocity is closer to being a constant, but not over short periods
Data Application
Using the idea that M2 velocity is stable, economists at the Federal Reserve Board developed an
inflation model based on M2 growth. The model suggested that the price level would adjust to an
equilibrium level, P*, that was determined mainly by the level of M2. See Jeffrey J. Hallman,
Richard D. Porter, and David H. Small, “Is the Price Level Tied to the M2 Monetary Aggregate
in the Long Run?” American Economic Review, September 1991, pp. 841–858. However, almost
immediately after this article came out, M2 velocity began behaving very unpredictably, and the
Federal Reserve deemphasized the use of M2 for policy purposes.
Policy Application
The Federal Reserve’s job of conducting monetary policy is made more complicated by sweep
programs. For an introduction to these problems, see “Sweep Accounts Lower Reserve Balances,
Complicate Fed Funds Targeting” in the Federal Reserve Bank of Atlanta Financial Update,
July–September 1999.
IV. Asset Market Equilibrium (Sec. 7.4)

A. Asset market equilibrium—an aggregation assumption
1. Assume that all assets can be grouped into two categories, money and nonmonetary assets
a. Money includes currency and checking accounts
(1) Pays interest rate im
(2) Supply is fixed at M
b. Nonmonetary assets include stocks, bonds, land, etc.
(1) Pays interest rate i  r   e
(2) Supply is fixed at NM
2. Asset market equilibrium occurs when quantity of money supplied equals quantity of money
demanded
a. md  nmd  total nominal wealth of an individual
b. Md  NMd  aggregate nominal wealth (from adding up individual wealth) (7.6)
c. M  NM  aggregate nominal wealth (supply of assets) (7.7)
d. Subtracting (7.7) from (7.6) gives (M  M)  (NM  NM)  0
d d
(7.8)
e. So the excess demand for money (Md  M) plus the excess demand for nonmonetary
assets (NMd  NM) equals 0.
f. So if money supply equals money demand, nonmonetary asset supply must equal
nonmonetary asset demand; then the entire asset market is in equilibrium
B. The asset market equilibrium condition
1. M/P  L(Y, r   e) (7.9) real money supply  real money demand
a. M is determined by the central bank
b.  e is fixed (for now)
c. The labor market determines the level of employment; using employment in the
production function determines Y

d. Given Y, the goods market equilibrium condition determines r
Numerical Problem 2 is an exercise in calculating the equilibrium interest rate.
2. With all the other variables in Eq. (7.9) determined, the asset market equilibrium condition
determines the price level
a. P  M/L(Y, r  e) (7.10)
b. The price level is the ratio of nominal money supply to real money demand
c. For example, doubling the money supply would double the price level
For exercises dealing with price level determination, see Numerical Problems 3 and 5 and
Analytical Problem 4.
You might wonder why we don’t show a diagram of money demand and money supply on the
horizontal axis and the real interest rate on the vertical axis at this point in the textbook. The
reason is that we need to talk about general equilibrium first, so we wait to introduce such a
diagram until Chapter 9. Otherwise, students would correctly wonder why the goods market
equilibrium diagram determines the real interest rate and at the same time the asset market
equilibrium diagram also determines the real interest rate. Instead, for now, we just give them the
idea that the asset market equilibrium determines the price level. Later, we will show how both
markets come into equilibrium simultaneously.
V. Money Growth and Inflation (Sec. 7.5)

A. The inflation rate is closely related to the growth rate of the money supply
1. Rewrite Eq. (7.10) in growth-rate terms:
P/P  M/M  L(Y, r e )/L(Y, r  e ) (7.11)
2. If the asset market is in equilibrium, the inflation rate equals the growth rate of the nominal
money supply minus the growth rate of real money demand
3. To predict inflation we must forecast both money supply growth and real money demand
growth
a. In long-run equilibrium, we will have i constant, so let’s look just at growth in Y
b. Let Y be the elasticity of money demand with respect to income
c. Then from Eq. (7.11),
  M/M  Y Y/Y (7.12)
d. Example: If output grows 3% per year, the income elasticity of money demand is 2/3, and
the money supply is growing at a 10% rate, then the inflation rate will be 8%
Numerical Problem 4 gives practice in using elasticities to predict inflation.
B. Application: money growth and inflation in the European countries in transition

1. Though the countries of Eastern Europe are becoming more market-oriented, Russia and
some others have high inflation because of rapid money growth

2. Both the growth rates of money demand and money supply affect inflation, but (in cases of
high inflation) usually growth of nominal money supply is the most important factor
a. For example, if the income elasticity of money demand were 2/3 and real output grew
15%, real money demand would grow 10% ( 2/3  15%); or if income fell 15%, real
money demand would fall 10%
b. So money demand doesn’t vary much, no matter how well or poorly an economy is doing,
but nominal money supply growth differs across countries by hundreds of percentage
points, so large inflation differences must be due to money supply, not
money demand
3. Text Figure 7.4 shows the link between money growth and inflation in these countries;
inflation is clearly positively associated with money growth
4. So why do countries allow money supplies to grow quickly, if they know it will cause
inflation?
a. They sometimes find that printing money is the only way to finance government
expenditures
b. This is especially true for very poor countries, or countries in political crisis
Data Application
For a review of the causes of inflation in the short run and long run in countries throughout the
world, see Larry Ball’s article, “What Causes Inflation?” Federal Reserve Bank of Philadelphia
Business Review, March/April 1993, pp. 3–12.
C. The inflation rate and the nominal interest rate

1. Expectations can’t be observed directly, except perhaps through surveys
2. If money growth is not expected to change much and if factors affecting money demand are
stable, inflation may not change much, so the expected inflation rate would be approximately
equal to the actual inflation rate
3. If the real interest rate is stable, then the nominal interest rate will move one for one with
inflation
Analytical Problem 3 shows how expected inflation depends on the money supply.
Data Application
There are many surveys of economists’ forecasts for inflation. The most well known monthly
survey is Blue Chip Economic Indicators. Two surveys that are available free of charge are the
quarterly Survey of Professional Forecasters, which began in 1968, and the semi-annual
Livingston Survey, which began in 1946. The Federal Reserve Bank of Philadelphia produces
both, and historical datasets on the surveys are available on the Internet at
http://www.phil.frb.org/ econ/forecast/index.html.
3. Text Figure 7.5 plots U.S. inflation and nominal interest rates
a. Inflation and nominal interest rates have tended to move together
b. But the real interest rate is clearly not constant
c. The real interest rate was negative in the mid-1970s and then became much higher and
positive in the late-1970s to early-1980s; the real interest rate turned negative again
following the financial crisis of 2008

Data Application
A careful attempt to measure the world real interest rate was undertaken by Robert J. Barro and
Xavier Sala-i-Martin, “World Real Interest Rates,” in O. Blanchard and S. Fischer, eds., NBER
Macroeconomics Annual, Cambridge, MA: MIT Press, 1990, pp. 15–61.
D. Application: measuring inflation expectations

1. How do we find out people’s expectations of inflation?
a. We could look at surveys
b. But a better way is to observe implicit expectations from bond interest rates
2. The U.S. government issues nominal bonds and Treasury Inflation-Protected Securities
(TIPS)
a. TIPS bonds make real interest payments by adjusting interest and principal for inflation
b. Compare nominal interest rate with real interest rate (text Figure 7.6)
3. The break-even inflation rate: interest rate on nominal bonds minus real interest rate on TIPS
bonds
a. The break-even inflation rate is a rough measure of expected inflation
b. TIPS bonds have lower inflation risk, so the break-even inflation rate may be too high
c. TIPS bonds do not have as liquid a market, so the break-even inflation rate may be too
low
d. The net effect of the two effects is likely to be small, so the break-even inflation rate may
be about right
4. The data show fluctuations in the break-even inflation rate (text Figure 7.7)
a. In contrast, the rate of expected inflation measured in surveys has been fairly constant
b. Either bond market participants have very different inflation expectations than
forecasters, or else the degree of inflation risk and liquidity on TIPS bonds varied
substantially from 1998 on

 Additional Issues for Classroom Discussion

1. How Has Technology Changed Money?
Ask your students how they think improved technology has changed the role of money in the economy.
They might mention such things as computer banking, which allow people to pay bills easier and to move
money between accounts without difficulty; phone banking, allowing people to deposit checks without
going to a bank; improved information systems, which allow banks to target credit cards for particular
types of borrowers and which reduce fraud by authorizing transactions instantaneously. Even newer
products include e-money, such as Bitcoin.
2. How Will Money’s Role Change in the Future?

Imagine an age in which the balance in your checking account is invested immediately and automatically
in the stock or bond market, earning substantially more interest than is typical today. Suppose all payments
become electronic, so we never need to touch a dollar bill. What role would money play in such a
payments system?
These questions have been discussed for the past 20 years, and while we’re getting closer to such a system,
it isn’t here yet. The idea is that we would no longer use currency as a store of value or as a medium of
exchange, but it might continue to be used as a unit of account. After all, we have to have some unit in
which we measure our investments and price our goods and services.
3. Should You Buy Indexed Bonds?

Given a choice between buying nominal bonds and indexed bonds, what would you choose? Ask your
students to list the pros and cons of buying indexed bonds.
You may need to give them a bit of historical background. Though introduced for the first time in the
United States in 1997, bonds whose nominal payments adjust for inflation have been available in other
countries for some time, beginning with Finland in 1945. Typically, countries have started issuing indexed
bonds after a bout with inflation.
As you discuss the bonds with your students, you may want to note a few special features that prevent the
bonds from being as desirable as an economist might like them to be. First, the principal of the bond is
adjusted regularly, so that it maintains its real value, but you must pay taxes immediately on the principal
adjustment. That is, before receiving the money, you get taxed on it. Also, because the U.S. government
didn’t want to allow a tax advantage to the indexed bonds, taxes on principal and interest are both based
on the nominal returns to the bonds, not the real returns. So the bonds don’t fully protect you against
inflation, since your taxes will be higher as the inflation rate becomes higher.

 Answers to Textbook Problems

Review Questions
1. Money is the economist’s term for assets that can be used in making payments, such as cash and
checking accounts. In everyday speech, people often use the term “money” to refer to their income or
wealth, but in economics money means only those assets that are widely used and accepted as
payment.
2. The three functions of money are (1) the medium of exchange function, which contributes to a better-
functioning economy by allowing people to make trades at a lower cost in time and effort than in a
barter economy; (2) the unit of account function, which provides a single, uniform measure of value;
and (3) the store of value function, by which money is a way of holding wealth that has high liquidity
and little risk.
3. The size of the nation’s money supply is determined by its central bank; in the United States, the
central bank is the Federal Reserve System. If all money is in the form of currency, the money supply
can be expanded if the central bank uses newly minted currency to buy financial assets from the
public or directly from the government itself. To reduce the money supply, the central bank can sell
financial assets to the public or the government, taking currency out of circulation.
4. The four characteristics of assets that are most important to wealth holders are (1) expected return,
(2) risk, (3) liquidity; and (4) time to maturity. Money has a low expected return compared with other
assets, low risk since it always maintains its nominal value, is the most liquid of all assets, and has the
lowest (zero) time to maturity.
5. The expectations theory of the term structure of interest rates originates in the idea that investors
compare bonds with different times to maturity and choose the ones that yield the highest return. In
equilibrium, the theory implies that the expected rate of return on an N-year bond should equal the
average of the expected rates of return on one-year bonds during the current year and the N – 1
succeeding years.
The expectations theory is not sufficient because on average, long-term interest rates exceed short-
term interest rates, in violation of the theory’s implications. To form a more accurate theory, a risk
premium must be added to the analysis.
6. The macroeconomic variables that have the greatest impact on money demand are the price level, real
income, and the nominal interest rate on other assets. The higher the price level, the higher the
demand for money, since more units of money are needed to carry out transactions. The higher the
level of real income, the higher the need for liquidity, and so the higher is money demand. When the
nominal interest rate on other assets is high, the quantity of money demanded is low, because the
opportunity cost of holding money (i.e., the interest you forgo on other assets because you are
holding money instead) is high.
7. Velocity is a measure of how often money “turns over” in a period. It is equal to nominal GDP
divided by the nominal money supply. The quantity theory of money assumes that velocity is
constant, which implies that real money demand is proportional to real income and is unaffected by
the real interest rate.

8. Equilibrium in the asset market is described by the condition that real money supply equals real
money demand because when supply equals demand for money, demand must also equal supply for
nonmonetary assets. The aggregation assumption that is needed for this is that we can lump all wealth
into two categories: (1) money and (2) nonmonetary assets.
9. In equilibrium, the price level is proportional to the nominal money supply; in particular it equals the
nominal money supply divided by real money demand. Similarly, the inflation rate is equal to the
growth rate of the nominal money supply minus the growth rate of real money demand.
10. Factors that could increase the public’s expected rate of inflation include a rise in money growth or a
decline in income growth. With no effect on the real interest rate, the increase in the expected
inflation rate would increase the nominal interest rate by the same amount.

Numerical Problems
1. For a two-year bond, according to the expectations theory, the interest rate would be the average of
the two one-year bonds, which is (6%  4%)/2  5%. Adding the risk premium of 0.5% gives an
interest rate on the two-year bond of 5.5%.
For the three-year bond, according to the expectations theory, the interest rate would be the average
of the three one-year bonds, which is (6%  4%  3%)/3  4.33%. Adding the risk premium of 1.0%
gives an interest rate on the three-year bond of 5.33%.
The yield curve would show the interest rate on a one-year bond of 6%, the interest rate on a two-year
bond of 5.55%, and the interest rate on a three-year bond of 5.33%, so it would be downward sloping,
which is called “inverted” in the market.
2. (a) Real money demand is
Md/P  500  0.2Y  1000i
   500  (0.2  1000)  (1000  0.10)
   600.
Nominal money demand is
Md  (Md/P)  P  600  100  60,000.
Velocity is
V  PY/Md  100  1000/60,000  1 2/3.
(b) Real money demand is unchanged, because neither Y nor i has changed.
Nominal money demand is
Md  (Md/P)  P  600  200  120,000.
Velocity is unchanged, because neither Y nor Md/P has changed, and we can write the equation
for velocity as
V  PY/Md  Y/(Md/P).
(c) It is useful to use the last expression for velocity,
V  Y/(Md/P)  Y/(500  0.2Y  1000i).
(1) Effect of increase in real income:
When i  0.10,
V  Y/[500  0.2Y – (1000  0.10)]
   Y/(400  0.2Y)
   1/[(400/Y)  0.2].
When Y increases, 400/Y decreases, so V increases. For example, if Y  2000, then V  2.5,
which is an increase over V  1 2/3 that we got when Y  1000.
(2) Effect of increase in the nominal interest rate:
When Y  1000, V  1000/[500  (0.2  1000)  1000i]
  1000/(700  1000i)
  1/(0.7  i).
When i increases, 0.7  i decreases, so V increases. For example, if i  0.20, then V  2,
which is an increase over V  1 2/3 that we got when i  0.10.
(3) Effect of increase in the price level:

There is no effect on velocity, since we can write velocity as a function just of Y and i.
Nominal money demand changes proportionally with the price level, so that real money
demand, and hence velocity, is unchanged.
3. (a) Md  $100,000  $50,000  [$5000  (i  im)  100]. (Multiplying by 100 is necessary since i and
im are in decimals, not percent.) Simplifying this expression, we get
Md  $50,000  $500,000(i  im).
(b) Bd  $50,000  $500,000(i  im).
Adding these together we get Md  Bd  $100,000, which is Mr. Midas’s initial wealth.
(c) This can be solved either by setting money supply equal to money demand, or by setting bond
supply equal to bond demand.
Md  Ms
$50,000  $500,000(i  im)  $20,000
$30,000  $500,000 i [Setting im  0]
i  0.06  6%
Bd  Bs
$50,000  $500,000i  $80,000
$500,000i  $30,000
i  0.06  6%
4. (a) From the equation MV  PY, we get M/P  Y/V. At equilibrium, Md  M, so Md/P  Y/V 
10,000/5  2000. Md  P  (Md/P)  2  2000  4000.
(b) From the equation MV  PY, P  MV/Y.
When M  5000, P  (5000  5)/10,000  2.5.
When M  6000, P  (6000  5)/10,000  3.
5. (a) P/P   Y Y/Y   0.5  6%  3%. The price level will be 3% lower.
(b) P/P   r r/r  (0.1)  0.1  1%. The price level will be 1% higher.
(c) With changes in both income and the real interest rate, to get an unchanged price level would
require Y Y/Y  r r/r  0, so [0.5  (Y – 100)/100]  [0.1  0.1]  0, so Y  102.
6. (a)  e  M/M  10%. i  r  e  15%. M/P  L  0.01  150/0.15  10. P  300/10  30.
(b)  e  /M  5%. i  r  e  10%. M/P  L  0.01  150/0.10  15. P  300/15  20. The
slowdown in money growth reduces expected inflation, increasing real money demand, thus
lowering the price level.
7. (a) With a constant real interest rate and zero expected inflation, inflation is given by the equation
  M/M  Y Y/Y. To get inflation equal to zero, the central bank should set money growth so
that M/M  Y Y/Y  2/3  0.045  0.03  3%. Note that the interest elasticity isn’t relevant,
since interest rates don’t change.
(b) Since V  PY/M, V/V  P/P  Y/Y – M/M
   0  0.045  0.03
   0.015

So velocity should rise 1.5% over the next year.
Analytical Problems
1. (a) People would probably take money out of checking accounts and put it into money market
mutual funds and money market deposit accounts. Money market mutual funds and money
market deposit accounts are included in M2 but are not part of M1. The result is a decrease in
M1, but no change in M2. M2 does not increase because M1 is part of M2, so the decrease in M1
offsets the increase in the rest of M2.
(b) This would reduce both M1 and M2, as people would have reduced need for money in checking
accounts, and home equity lines of credit are not included in either M1 or M2.
(c) If people fear a stock market collapse, they will want greater liquidity, so they will hold more
money. Also, since stocks are an alternative asset to money, and the expected return to stocks has
fallen, money demand will increase. Both effects will lead to people investing less in stocks and
more in cash, checking accounts, and other items that provide liquidity and safety, so M1 and M2
will both rise.
(d) People would have less need for money in checking accounts, and would put more in savings
deposits. So M1 will decrease, while M2 will remain unchanged. (Again, M1 is part of M2, so
reducing the amount that is in M1, and increasing the amount that is in M2 but not in M1, has no
effect on M2.)
(e) If currency demand falls, this decreases M1, thus also decreasing M2.
2. The general rise in velocity from 1959 to 1980 is most likely due to changes in income, in interest
rates, and in financial institutions. Higher income led to a less than proportional rise in real money
demand, so velocity increased. Rising inflation and rising nominal interest rates in this period led
people to seek alternatives to non–interest-bearing money, such as money market mutual funds.
The result was lower money demand, and thus higher velocity. Financial innovations also reduced the
need for money. Examples include the development of cash management accounts and the use of
automated teller machines.
3. (a) New cigarettes mean an increase in the money supply. With higher nominal money supply and
no change in real money demand, the equilibrium price level must rise.
(b) If people anticipate prices rising when the new cigarettes arrive, they will hold less money so that
they will not lose purchasing power when prices go up. But if their real money demand is
reduced, with the same nominal money supply the equilibrium price level must rise. The result is
that when prices are anticipated to rise in the future, people may take actions that cause prices to
rise immediately.
4. (a) A temporary increase in government purchases reduces national saving, causing the real interest
rate to rise for a fixed level of income. If the real interest rate is higher, then real money demand
will be lower. So prices must rise to make money supply equal money demand. The result is that
output is unchanged, the real interest rate increases, and the price level increases.
(b) When expected inflation falls, real money demand increases. With no effect on employment or
saving and investment, output and the real interest rate remain unchanged. With higher real
money demand and an unchanged nominal money supply, the equilibrium price level must
decline. So output and the real interest rate are unchanged and prices decline.

(c) When labor supply rises, full-employment output increases. Also, with higher output, saving will
increase, so the real interest rate will decline. Both higher output and a lower real interest rate
increase real money demand. The price level must decline to equate money supply with money
demand. The result is an increase in output and a decrease in both the real interest rate and the
price level.
(d) When the interest rate paid on money increases, real money demand rises. With no effect on
employment or saving and investment, output and the real interest rate remain unchanged. With
higher real money demand and an unchanged nominal money supply, the equilibrium price level
must decline. So output and the real interest rate are unchanged and prices decline.
Working with Macroeconomic Data

1. Answers vary, depending on recent data.
2. In the 1960s and early 1970s, M1 growth was more closely related to inflation. In the 1980s, M2 growth was
more closely related to inflation. The relationships are stronger in the long run than in the short run. The
relationship between M2 growth and inflation weakened after 1990.
3.
a. Interest rates move in the same direction as inflation. That is not surprising because if real interest rates do
not change too much, and because the nominal interest rate equals the real interest rate plus the inflation rate
(if actual and expected inflation rates are similar), then nominal interest rates will move in the same
direction as inflation.
b. The three-month rate is more sensitive to current changes in inflation. The ten-year rate would be sensitive
to long-run changes in inflation, but many inflation movements are short-lived.

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De Gêvres shrugged. "Oh, not necessarily. You shall judge." He glanced
meditatively at her feet, tapped his snuff-box, and began to speak just as
Marchon finished the first curl. "Without doubt, madame, even after the
deplorable past evening, you still recollect the rather outré events of the day
before. You cannot yet have forgotten the last Rambouillet chase, the gage
you offered, his Majesty's unfortunate chagrin, and the intrepid, if rash, ardor
of your young cousin, Count Claude?"
"Thus far my memory carries me, monsieur. Continue."
"Well! The rest is, indeed, curious. In spite of the Count's heroic
gallantry, he appeared, later in the day, to have repented somewhat of having
so eagerly dared the royal displeasure. A company of my friends were so
good as to visit, with me, my hôtel—you know its condition—for play, on
this very evening. By great good fortune, his Majesty, together with a
companion, did us the honor himself to join our party a little later. When the
King beheld his successful rival, the Count, seated with us, he instantly
proposed that the two of them play a round for high stakes. Louis, madame,
offered a diamond star—valued, perhaps, at fifty thousand francs, or more,
against—"
"My glove."
"Even so. You have, perhaps, heard the tale?" queried the Duke, hastily,
with a suspicion of anxiety in his voice.
Mme. de Châteauroux noticed this, but her face continued to be as

impassive as that of her smiling mandarin. "You forget my evening,
monsieur. I know nothing. Continue, I beg of you."
"Monsieur le Marquis de Coigny and the Comte de Maurepas!"

announced the valet.
De Gêvres coughed, but his face expressed none of the disappointment

that he felt.
Mme. de Châteauroux greeted both gentlemen with imperturbable

courtesy, and the three nobles, after her salutes were over, exchanged
greetings. Then the favorite said, at once:
"Pray be seated, messieurs. M. de Gêvres is telling me a most interesting
anecdote. Pardon if I ask him to finish it. Since it in a way concerns myself, I
am so vain as to be curious."
The late-comers bowed and looked at the Duke, who, in that instant, had
mentally sounded the intruders, considered his course, and decided to risk a
continuance of his original plan. Without any noticeable hesitation, the story
went on.
"As I said, his Majesty and the Count de Mailly were to play together for
possession of the glove. The King threw first—four and three. De Mailly
came next with five and two."
"Ah!" murmured de Coigny.
"Again Louis with ten, and the Count turned precisely the same number.
His Majesty was visibly tingling with anxiety. He was about to throw for the
last time, with a prayer to the gods, when the Count—um—took pity on
him."
"He offered the glove?" asked madame, quietly.
De Gêvres bowed. "In a way, Duchess. He offered to—exchange the

stakes."
"Oh!" cried Maurepas, angrily.
"Dastardly!" muttered de Coigny.
Mme. de Châteauroux flushed scarlet with anger beneath her powder.
Little Marchon, trained to high gallantry by long experience in haunts of

the elect, left an iron in too long, and slightly scorched a lock of hair. His
little eyes winked furiously with disapproval of the Count.
"Monsieur le Marquis de Mailly-Nesle!" came the announcement.
De Gêvres coughed again; and, amid rather a strained silence, Henri

entered the apartment of his sister.
He looked about him for a moment or two with some curiosity, feeling
the awkwardness of his arrival, and considering what it would be wise to
say. Maurepas, the diplomat, recovered himself quickly, remarking, in a tone
which relieved them all: "This brother's devotion, my dear Marquis, is
gratifying to behold. One is really never so certain of finding you anywhere
at a given hour as here, in your sister's boudoir."
"Mme. de Coigny has, I believe, no mornings à la toilette," observed

Mme. de Coigny's husband.
Maurepas looked sharply at the speaker, while the others smiled, and the
Duchess made every one still easier by laughing lightly.
"Her sang-froid is unapproachable," murmured de Gêvres to Maurepas,

behind his hand.
"You have certainly put it to strong test this morning," was the reply,
rather coldly given.
"L'Abbé de St. Pierre and l'Abbé Devries!"
The two ecclesiastics entered from the antechamber and advanced, side
by side, towards the Duchess. The taller of the two, St. Pierre, was a very
desirable person in salon society, and could turn as neat a compliment or as
fine an epigram in spontaneous verse as any member in the "rhyming
brotherhood." At sight of St. Pierre's companion, who was a stranger here,
the Marquis de Coigny gave a sudden, imperceptible start, and Henri de
Mailly suppressed an exclamation.
"Madame la Duchesse, permit me to present to you my friend and

colleague, l'Abbé Bertrand Devries, of Fontainebleau."
"I am charmed to see you both," deigned her Grace, giving her hand to
St. Pierre, while she narrowly scrutinized the slight figure and delicate,
ascetic face of the other young priest. The mild blue eyes met hers for a
single instant, then dropped uneasily, as their owner bowed without
speaking, and passed over to a small sofa, where, after a second's hesitation,
he sat down. St. Pierre, who seemed to cherish some anxiety as to his new
protégé's conduct, followed and remained beside him.
"Unused to the boudoir, one would imagine. It is unusual for one of his
order. I am astonished that St. Pierre should have brought him to make a
début before you," observed de Gêvres to la Châteauroux, who had not yet
removed her eyes from the new priest.
"St. Pierre knows my fondness for fresh faces," she replied, indifferently,
picking up a mirror to examine the coiffure, just as her lackey entered the
room with small glasses of negus, which were passed among the party.
While de Coigny raised a glass to his lips he turned towards Devries.

"You have spent all your time in Fontainebleau, M. Devries?" he asked,
seriously.
"By no means, monsieur," was the answer, given in a light tenor voice.
"Indeed, for the last two weeks I have been working in Paris."
"Working! And what, if my curiosity is not distasteful to you, is your

work?" queried madame, still toying with the mirror.
"By all means," murmured de Gêvres, comfortably, after finishing his

mild refreshment, "let us hear of some work. It soothes one's nerves
inexpressibly."
Devries' blue eyes turned slowly till they rested on the slender figure of
the Duke, clad in his gray satin suit, his white hands half hidden in lace,
toying with a silver snuff-box. The eyes gleamed oddly, half with
amusement, half with something else—weariness?—disgust?—surely it was
not ennui; and yet—in an avowed courtier, that was what the look would
have seemed to express.
"I will, then, soothe your nerves, if you wish it, sir. My work certainly
was very real. For the past two weeks my abode has been in the Faubourg St.
Antoine, but my days were spent in a very different part of the city. At dawn
each morning, in company with my colleague—not M. de St. Pierre, here—I
left behind those houses whose inmates rejoiced in clothes to cover
themselves, in money enough to purchase a bone for soup daily, and who
were even sometimes able to give away a piece of black bread to a beggar.
These luxurious places we left, I say, and together descended into hell. It
might amuse you still more, monsieur, to behold the alleys, the courts, the
kennels, the holes filled with living filth into the midst of which we went.
There women disfigure or cripple their children for life in order to give them
a means of livelihood, that they may become successful beggars; there wine
is not heard of, but alcohol is far commoner than bread; there you may buy
souls for a quart of brandy, but must deliver your own into their keeping if
you have not the wherewithal to appease, for a moment, their hatred of you,
who are clean, who are fed, who are warm. Cleanliness down there is a
crime. Ah! how they hate you, those dwellers in the Hell of Earth! How they
hate us, and how they curse God for the lives they must lead! The name of
God is never used except in oaths. And yet a girl, whose dying child I
washed, knew how to bless me one day there. It seems to me that they might
all learn how, if opportunity were but given them. There has been some
bitter weather lately, when the frozen Seine has been a highway for trades-
people. Those creatures among whom I went make no change from their
summer toilets, gentlemen. Half—all the children—are quite naked. The
women have one garment, and their hair. The men are clad in blouses, with
perhaps a pair of sabots, if they can fight well to obtain them, or are ready to
do murder without a qualm to keep them in their possession. It is among
these people that I worked, Monsieur—de Gêvres—with my colleague."
"How eminently disgusting!" replied the Duke, calmly, but his remark
was not pleasing to the rest of those present, who had been actually affected
by the description. Henri de Mailly had risen to his feet, and, after a
moment's pause, asked, rather harshly, "Who was your colleague,
monsieur?"
The Marquis de Coigny shot a quick, warning glance at Henri, and raised
his hand. "Monsieur l'Abbé, I am interested in your story. Would you do me
the honor to breakfast with me this morning, and tell me more of this life?"
The little audience stared, and la Châteauroux lifted her head rather
haughtily. Devries appeared, for some reason, to be very much amused.
"You are too good, Monsieur le Marquis. I have already partaken of my

morning crust. Besides, you, doubtless, are happy enough to be daily in the
company of Mme. de Châteauroux; while I, monsieur, am a poor priest, not
often admitted to the dwellings of the highest." He rolled his eyes towards
the figure of the Duchess, who was becoming visibly gracious under the
effect of this slight compliment.
"You are not, then, a sharer of the opinions of those poor creatures
amongst whom you have worked, and who, as you truthfully suggest, have
some little cause to hate us, who have so much more in life than they?"
queried Maurepas, with the interest of a Minister of the Interior.
"No, monsieur, assuredly I have no feeling of enmity towards the

nobility of France. I should have no right. You see, I know very—very lit—"
Suddenly Devries caught the eyes of St. Pierre fixed on him in so curious a
glance that he was forced to stop speaking. His mouth began to twitch at the
corners. He shook with an inward spasm, and finally lay back upon the sofa,
emitting peal after peal of silvery, feminine laughter.
"Victorine!" cried the Duchess, starting from her chair. "Victorine, you
madcap! So you have come back again!"
"Mme. de Coigny insisted," murmured St. Pierre, uncertain of his

position.
The rest of the gentlemen sat perfectly still, staring at the little Marquise,
and trying, out of some sense of propriety or gallantry, to keep from joining
in her infectious laughter. Only Henri de Mailly sat near a window, his head
on his fist, staring gloomily out upon the barren, stone-paved court.
"My dear madame!" cried Maurepas, when she had grown tearful with
laughter, "your disclosure has done me an excellent turn. It has saved me
five hundred livres. I was about thus to impoverish myself that you might be
permitted to get still closer to heaven by spending another week in the
criminal quarter distributing them."
The Marquise de Coigny grew suddenly serious again. "M. de Maurepas,

let me take you at your word. I beg that you will send the money to him who
was my companion in the work—l'Abbé de Bernis."
"Oh!—François de Bernis?" asked St. Pierre, in quick surprise. "I have

met him at the Vincent de Paul."
"Her Majesty, I believe, receives him at times into her most religious
coterie," put in de Maurepas.
"Well, since you know who he is, I will continue, if you will permit me. I
beg that you will all, at least, believe that what I have said concerning my
occupation in Paris was wholly serious. Indeed, indeed, I am in the highest
sympathy with the work of the Jesuit fathers among the people; and there are
few men in our world whom I—respect—as I do M. de Bernis."
At these words, so solemnly spoken that they could not but impress the
listeners with their sincerity, the eyebrows of St. Pierre went up with
surprise, though he remained silent. As a matter of fact, the reputation of the
Abbé François Joachim de Pierre de Bernis was not noted for its sanctity.
"Will you, then, permit me, madame, to double my first offer?" said de
Maurepas, with his mind on the treasury. "I will to-day send you a note for
one thousand livres, which I beg that you will dispense in charity."
"M. de Maurepas, I wish that you could imagine what your word will
mean to those poor creatures."
"And shall you yourself return to Paris with the money, madame?"
inquired de Gêvres, smiling slightly.
De Coigny moved as though he would speak, but his wife answered

immediately, in his stead: "No, Monsieur le Duc. I have no intention of
taking permanently to a black gown. For two weeks it has occupied me
satisfactorily to attend the poor. Now I shall come back to Court till I am
again fatigued by all of you. After that I must devise a new amusement.
Really—you all know my one eternal vow: I will not become successor to
Mme. du Deffant. Death, if you like,—never such ennui as hers. M. de
Mailly-Nesle, will you give—"
She did not finish. Henri had sprung quickly to his feet, but de Coigny
was before him. "Pardon, Monsieur le Marquis," said he, with great courtesy,
"will you allow me, to-day, instead. To-morrow I shall once more relinquish
all to you."
De Mailly-Nesle could not, in reason, refuse the request, though it was
against the conventions. He merely bowed as husband and wife, having
variously saluted la Châteauroux and the rest of the company, passed
together out of the boudoir.
"Mme. Victorine's eccentricity and her terror of being bored are excellent
things. The husband seems to fall in love with her more violently than ever
after each adventure."
"Ah, Madame la Marquise is too charming to be anything but successful

everywhere. Really, Henri, you and de Bernis—"
Henri, angry at the first word, turned upon the Duke: "Monsieur, I would
inform you that Mme. de Coigny is—"
"Ob yes, yes, yes! Pardon me," de Gêvres rose, "I understand perfectly
that Mme. Victorine is the most virtuous, as she is the most charming, of
women. Madame la Duchesse, I have been with you seemingly but one
moment, and yet an hour has passed. His Majesty will be receiving the little
entries. I bid you au revoir."
The Duchess held out her hand. The courtier kissed it, bowed to the three
remaining men, and gracefully left the boudoir. When the door shut behind
him a breath of fresher air crept through the room. Mailly-Nesle, who had
been restlessly pacing round and round among the tables and chairs, paused.
De Maurepas drew a tabouret to madame's side, and began to talk with her in
the intimate and inimitably dignified manner that was his peculiar talent. St.
Pierre was thoughtfully regarding nothing, when Henri approached and sat
down beside him. Just as they began to speak together, Marchon stepped
back a little from the chair of la Châteauroux.
"Madame," he cried, "the coiffure is finished."
At the same instant the door to the antechamber again flew open. "The
Comte de Mailly!" announced the valet.
There was a second's pause and Claude ran into the room. "My dear
cousin!" he cried, buoyantly, hurrying towards her.
Mme. de Châteauroux rose slowly from her place, stared at the new-
comer for an instant with the insolence which only an insulted woman can
use, then deliberately turned her back and moved across the room. Maurepas
was already on his feet, and now, seizing his opportunity, he bowed to the
woman, indicated Henri and the abbé in his glance, passed Claude with the
barest recognition, and left the room congratulating himself on his adroit
escape before the storm. Mailly-Nesle and St. Pierre sat perfectly still for an
instant out of astonishment. Then, happily, the abbé came to himself, rose,
repeated the performance of the minister, and hastened from the
unpleasantness. The instant that he was gone Claude broke his crimsoning
silence in a somewhat tremulous voice:
"Name of God, Marie, what have I done?"
Madame was at her dressing-table. Picking up a small mirror, she

retouched her left cheek.
"Marie," said Henri, gently, "it is but fair that you let him know his
fault."
A shiver of anger passed over the frame of la Châteauroux. Then,

suddenly whirling about till she faced Claude, she whispered, harshly: "My
gauntlet, Monsieur le Comte; my white gauntlet! Return it to me!"
Again Claude flushed, wretchedly, while his cousin spoke: "He has it not
to return, Marie."
She turned then upon her brother. "So you, also, know this insult, and
you counsel me to—let him know his fault! Ah, but your school of gallantry
was fine!"
"This insult!" repeated Claude, stupidly.
"Fool! Do you think I do not know it?"
Count and Marquis alike stood perfectly still, staring at each other.
"Your innocence is awkwardly done," commented madame. "Show me

the price, Monsieur Claude, for which you sold my gage."
"Price!" echoed Henri, angrily. But Claude drew a long breath.
"Ah! Now I begin, I but begin, to understand. Which was it that came to
tell the story, madame? Was it d'Epernon, or Gêvres, or Richelieu who
twisted the account of a forced act into one of voluntary avarice?"
The favorite shrugged. "Charming words! I make you my compliments

on your heroic air. Will you, then, confront M. de Gêvres before me?"
"Most willingly, madame! Afterwards, by the good God, I'll run him
through."
La Châteauroux bent her head, and there was silence till she lifted it
again to face her young cousin. His eyes answered her penetrating glance
steadily, eagerly, honestly. And thereupon madame began to turn certain
matters over in her mind. She was no novice in Court intrigue; neither had
she any great faith to break with de Gêvres. It was a long moment; but when
it ended, the storm was over.
"How did it happen, Claude?"
"I gave the gauntlet to the King, when, man to man, he was beaten at
dice."
"You received nothing in return?"
Claude was uncomfortable, but he did not hesitate. "Yes," he said, with
lowered eyes. "I have brought it to you. I hate it."
From one of the great pockets in the side of his coat he drew a small, flat
box, which he handed to his cousin. She received it in silence, opened it, and
gazed upon the royal star. The frown had settled again over her face.
Suddenly, with a quick impulse, she pulled open one of the small windows
which looked down upon the Court of Marbles.
"Claude, take this and throw it out—there," she commanded.

"'CLAUDE—TAKE THIS AND THROW IT OUT—THERE'"
De Mailly was at her side in two steps. Eagerly he seized the jewels and
flung them, with angry satisfaction, far out upon the stones. La Châteauroux
looked at him quizzically for an instant, then suddenly held out both hands to
him. He did not fall upon his knee, as a courtier should have done; but threw
his arms triumphantly about her and bent his powdered head over hers.
"Um," muttered Henri, indistinctly, "methinks I would better go and seek

the fallen star."
CHAPTER III
The Gallery of Mirrors
The 16th of January fell on a Saturday, on the evening of which day the
King held his usual weekly assembly in the formal halls of the palace. These
affairs were not loved by Louis, whose tastes ran in more unostentatious
directions; but they were a part of his inheritance, coming to him with the
throne, his hour of getting up in the morning, and the national debt; so he
made no audible murmur, and ordinarily presented a resplendent appearance
and a dignified sulkiness on these occasions. It was his custom to enter the
Hall of Battles or the Gallery of Mirrors, in company with his consort,
between half-past eight and nine o'clock. Since no courtier was supposed to
make his entrance after the King, the great rooms were generally thronged at
an early hour, and the first dance began at nine precisely.
At a quarter to seven on this particular Saturday, four candles burned in

the Gallery of Mirrors, and their petty light made of that usually magnificent
place a shadowy, dreary gulf of gloom. Ordinarily, at this hour, the salon was
deserted. To-night, it appeared, one individual was unhappy enough to find
the place harmonious with his mood. This solitaire, who had twice paced the
length of the hall, finally seated himself on a tabouret with his back to the
wall, and, leaning his head against a mirror, gave himself up to some
decidedly uncomfortable thoughts. It was Claude de Mailly who was young
enough and unwise enough to surrender himself to his mood in such a place,
at such an hour. Only late in life does the courtier learn how dangerous a
thing is melancholy. Claude had not come to this yet; and for that reason,
through one long hour, he remained in darkness, meditating upon a situation
which he could not, or, more properly, would not, help. For Claude's eyes
were well open to the precarious position into which he had got himself;
they were open even to his more than possible fall. Nor was he ignorant of
the direction in which salvation lay—the instant bending to Louis' wishes,
repudiation of the favorite, and devotion to some other woman. But, to his
honor be it said, Claude de Mailly was deeply enough in love and loyal
enough by nature to scorn the very contemplation of such action. He could
not see very far into the future. He dared not try to pierce the veil that hid the
to-come from him. He would not think of consequences. Perhaps he was not
capable of imagining them; for, to him, life and Versailles were synonymous
terms, and the world beyond was space.
His vague and varied meditations were broken in upon by the appearance
of eight lackeys, who had come to light the room for the evening. Claude
rose from his place and slipped away by a side-door. He had nothing to do,
nowhere in particular to go. The Œil-de-Bœuf would be deserted. The Court
was dressing. An hour before, dismal with the loneliness of the gray sky and
the falling snow, he had left his rooms in Versailles. He was dressed for the
evening, but had had nothing to eat since the dinner hour. An idea came to
him presently, and he bent his steps in the direction of the Staircase of the
Ambassadors. At the head of this, on the second floor, he halted, knocking at
a well-known door. It was opened after a moment by a well-known lackey.
Claude thrust a coin into the man's hand, and passed out of the antechamber,
through a half-lighted salon, and into the Persian boudoir where sat Mme. de
Châteauroux and Victorine de Coigny, comfortably taking tea à l'anglaise
together, and talking as only women, and women of an unholy but very
entertaining Court, can talk. The little Marquise was dressed for the
assembly. The duchess was coiffed, patched, and rouged, but en négligé. She
rose nervously at Claude's entrance.
"Claude! Claude! How unceremonious you are!"
"And did you hear what we were saying of you, monsieur?" asked
Victorine, smiling mischievously, as she gave him her hand.
"Fortunately for my vanity, madame, no," he returned, bending over it;

then, at her ripple of laughter, he crossed to his cousin, took her proffered
fingers, but, instead of kissing them, seized them in both his hands, clasped
them close to his breast, and looked searchingly into her eyes.
"Anne, Anne, I have suffered so!" he murmured. "I wonder—if you

care?"
Mme. de Coigny sprang up. "At least, monsieur, give me time to retire!
Your ardor is so remarkable!"
The Duchess laughed and gently withdrew her hand from Claude's grasp.
She was in excellent spirits. Never had she passed a more uniformly
successful week at Court than the one just ending. If she had purchased
much royal devotion, and much toadyism from hitherto lofty personages at
Claude's expense, why—that was Claude's affair. His career was not in her
keeping; but she could, and did, treat him very amiably in private for the
sake of the fierce jealousy which he was inspiring in her royal lover. It was
one of her cleverest manœuvres, one that had been tried before, this playing
some quite insignificant little person against Louis of France; for the King
was ardently in love for the first time, and had not yet grown old in the
knowledge of woman's ways.
"Come, Claude," entreated madame, "sit here, and take at least one dish
of this charming beverage. And the patties are by Mouthier himself. You
must taste them; and Mme. de Coigny shall entertain you, while my dress is
put on."
He accepted the invitation readily enough, seated himself at the little

table, and began an attack on Mouthier's patties with such good-will that
Mme. de Coigny held up her hands.
"Ciel, Monsieur le Comte! Do you protest that you are a lover, with such
an appetite? 'Tis more worthy the Court of Miracles!"
Claude put down his tea. "Ah, madame—the Court of Miracles! Do you
know that for the last days I have heard nothing on every side but
conversations about the last experiment of the Marquise de Coigny? May I
ask if it proved a really successful remedy for your deplorable ennui?"
Mme. de Coigny slightly smiled. "Indeed, monsieur, its efficacy was but
too great. At the time, I was in a dream of pity and of—happiness. Since my
return, my wretchedness is greater than ever before. Pouf! How can you bear
the air of this hideous place? It stifles! It poisons! It kills!"
"I hear," remarked Mme. de Châteauroux, from her toilet table, "that
Griffet will, in a few days, formally present Monsieur l'Abbé de Bernis to
her Majesty as eligible to the post of third chaplain to the Dauphin. Now, if it
were desirable, it is possible that the King might"—she touched an eyebrow
—"might be prevailed upon to ask him to supper with the royal family."
Victorine de Coigny moved uneasily, and Claude noted, from beneath his
lids, that a sudden color, which did not quite match the rouge, had started
into her face. "Do not jest, Marie," she murmured, half to herself.
"Oh, it is quite a possibility, my dear! If you ask it, I will—give him a

salon here on a Tuesday evening. Will that please you? You will be able,
then, to—"
Victorine sprang nervously to her feet. "Good Heaven, Marie! Do you

not know that M. de Bernis considers me a man? How could you dream that
I would wish him to know my sex? I—I beg of you—do not let me meet him
here, or—or—if I should, at least you must disclose nothing. It would be too
mortifying."
Mme. de Châteauroux paused in the manipulation of her gown to look at

her friend. Never before had she beheld Victorine de Coigny in confusion;
never had she seen her betray the smallest sign of emotion about any thing or
person. Claude also regarded her with unfeigned interest. Presently he turned
slowly to his cousin.
"Madame," he said, softly, "why will you not make a pilgrimage with me
into the Court of Miracles?"
"Dear Claude," she answered, smiling dreamily, "when I go there, I must

carry with me only an image of—the King."
And, while Claude colored with displeasure, Victorine turned her head to
hide an irrepressible smile.
By this time the candles in the great gallery were all lighted, and the
mirrors reflected the brilliant colors of a richly costumed and continually
increasing throng that passed and repassed in endless procession before
them. No woman here was untitled; few of the men had less than five, and
many had twenty, generations of unsmirched aristocracy behind them. Many
were there who did not own the clothes upon their backs; and many others
whose debts would have impoverished a half-dozen of the wealthiest of the
bourgeoisie. Yet few ever went abroad with an empty pocket; and money
was generally their last source of worry. Here passed the Marquis de Sauvré,
a member of the King's intimate circle, a page of the Court, whose estates
were mortgaged, and whose Paris hôtel was almost dismantled of furniture,
in an unpaid-for dress of cherry-and-white satin, with pearls worth fifty
thousand livres on him, arm in arm with M. de la Poplinière, a farmer-
general, worth forty millions, but not attired with half the extravagance of
his companion. In a corner, taking snuff, and commenting on the degeneracy
of the grand manner since the last reign, were the old Duc de Charost, who
had attached himself to the Queen and the religious party; the Duc de Duras,
who lived on the influence of his wife's implacable etiquette; and M. de
Pont-de-Vesle, a successful diplomatist in a small way, and the most
disagreeably ubiquitous man at Court. Opposite them the Marquis
d'Entragues, a man whose scutcheon had come into existence two hundred
years before, beginning with a bar sinister to the discredit of a certain King
of France, and M. Marchais, at whose hôtel could be found the best vin d'Ai
in the kingdom, and who was a favorite with Louis on that account, were
discussing, with the Comtesse d'Estrades, the pompous intrigues of Mme. de
Grammont. Every one waited, more or less eagerly, first, for the appearance
of the favorite; secondly, for the arrival of the King.
"It is half-past eight," remarked de Coigny to Charost, whose group he

had just joined. "I am unable to discover madame, my wife. She must be
with Mme. de Châteauroux, who, by-the-way, is late."
"The Duchess is actually more haughty than la Montespan was,"

returned the old Duke. "The Fourteenth Louis showed less indulgence than
his present Majesty."
"Possibly. But where is the favorite of the old Court with the presence,
the magnificence, the carriage of the present Duchess?" cried Duras,
popularly.
"Quite so," murmured Pont-de-Vesle, rubbing his chin.
"Well—yes. She has, perhaps, the manner," admitted Charost,

unwillingly.
"And she is here!" cried de Coigny.
"Ah! What a carriage! What a glance! What a toilet!" cried Duras,

rapturously.
"It is not difficult to perceive that she means, at all events, to wreck her
cousin as she did the little d'Agenois."
"It is de Mailly's own fault, then. He is mad, to betray such devotion.

One would never believe that he had been brought up at Court."
"You are quite right, M. de Charost. Such honesty and truth as his are
absurdities that we do not often discover here," observed de Coigny,
shrugging his shoulders.
The Duchess, handed by Claude, whose eyes were fastened on her,

followed by Victorine and Henri de Mailly-Nesle, was entering the salon.
The perfumed crowd, half unconsciously, drew back a little on either side to
make a way for her as they did for the King. Her bearing was certainly royal.
The heavy velvet of her robe, with its glittering silver fern-leaves, swept
about her like a coronation mantle. Her breast glittered with a mass of
diamonds, and in her hair were five stars, fastened together like a coronet.
She was turned slightly towards Claude, and noticed no one till he had
finished what he was saying to her, so that all had time to note the manner of
her entrance and the details of the costume. Then, as Richelieu pressed
towards her, she gently dropped Claude's hand and turned aside.
He stood still for a moment where she left him, till he saw her quite
surrounded with men and women. Then he moved away, dreading the next
hour, but buoyed up with the thought of a promise she had given before they
left her apartments. There were few people about him whom he did not
know, and he bowed continually from right to left as he walked aimlessly
through the throng. Oddly enough, however, as it seemed to him, the salutes
that were returned were coldly formal. No one addressed him beyond a
chilly "Good-evening," and Mme. de Grammont passed by with her eyes
fixed on some distant goal. Claude's heart was beginning to throb a little, and
he could feel the color surge over his face. Presently there was a touch upon
his arm. Quickly he turned his head. M. de Berryer was beside him.
"Good-evening, M. de Mailly. Your face is troubled. In the midst of such

a scene the expression is unusual. Am I impertinent to ask if I can be of
service?"
Claude gave the man a quick and searching glance.
"Yes," he said, after a pause, "you can tell me, if you will, your idea as to
why I am in disfavor with—all these. And, also, if you will, answer this
question: is my present position dangerous?"
They had drawn a little to one side of the greatest press while Claude
spoke. De Berryer stopped an instant to think before he replied; but when he
did so it was evidently with perfect honesty.
"My dear Count, you are experiencing these little and very disagreeable
cuts, in my opinion, first, because of your reckless attentions in spite of his
Majesty's open displeasure; secondly, because of an unpleasant mistake in
the story of your game with the King on Tuesday evening. The first matter
you alone can rectify, but the method is simple. In the second, I will try to
assist you. As to the—possible danger of your position—well, let me advise
you to—do what may be done while it still is possible. Your pardon. Au
revoir."
The Chief of Police, bowing courteously, turned aside and was lost in the
crowd before Claude could say anything further. To tell the truth, the last
words had nonplussed de Mailly not a little. Presently, however, he flung up
his head, and, passing his hand over his forehead, muttered to himself: "You
may be right—God knows you may be right. But no honest man gives up the
woman he loves because his rival is a king. And, from my soul, I believe that
in time Marie must love me in spite of all!" And so the lights grew a little
brighter as Claude passed on again through the Gallery of Mirrors.
It was a quarter to nine, and the company grew slightly bored. In three-
quarters of an hour two hundred people can easily dispose of ten new
scandals, redigest twenty ancient ones, and anticipate as many as the
remaining minutes will permit. But undiluted gossip, spiced with epigram
and heated with wit though it may be, grows nauseating after a while, if
taken in too great quantities; and, through the great room, to-night, there
were enough chronic dispeptics of this class to make conversation finally
begin to lag. The abstract murmur, to which Claude was moodily listening,
changed in character. Suddenly, as the cries of the ushers at last rang out, it
became as present wine to former tepid milk:
"Mesdames, messieurs, their Majesties! Way for the King! Way for the
Queen!—Will you have the goodness to move just here."
The four royal ushers, with their white staffs, passed down the room,
forming an alley for the passage of the King. No ribbons were used, as in the
days of the fourteenth Louis. The courtiers were better trained now. They
pressed back voluntarily on either side, leaving a very well-formed lane
between the two crowds. A quick silence fell over the room and the circling
throng was still. Each one had sought the company in which he or she
wished to stand. For none knew just how long it would take his Majesty to
reach the other end of the room, where he would open the first minuet.
Claude, by a series of delicate manœuvres, had reached the side of Mme. de
Châteauroux, and, despite the silence, found opportunity to whisper:
"You will not forget—that you have promised me the first dance?"
And the favorite, looking into her cousin's eyes, felt, even in her
heartless heart, a little throb of pity for the utter abandon of his infatuation.
"I do not forget, mon cher. But thou shouldst have kept away from me
till the progress was over."
Claude shrugged and smiled happily.
"Mesdames, messieurs, their Majesties!"
Two more ushers entered and passed rapidly down the aisle, backward.
Louis and his wife, hand in hand, followed after. The King was, as usual,
magnificently dressed and glittering with jewels. His face, however, was as
unpropitious as possible. He wore his most bored and fretful look, and he
walked straight down the room for a distance of twenty-five feet, heedless of
his wife, without glancing at a soul. Marie Leczinska, on the contrary,
carelessly attired in a costume of deep brownish-red brocade, pale of face,
tired-eyed, yet wearing a curiously contented look, bowed timidly to three or
four of her dames du palais and some of her abbés, who had the grace to
return the salutes with a show of respect that was born of pity. The company,
however, quickly felt the chilling breath of the master's ill-humor.
"Parbleu!" muttered de Gêvres to Richelieu, as they stood together at the
far end of the gallery, "madame herself is to be ignored to-night."
But the Duke was mistaken. His Majesty, in his rapid walk, had seen
many more things than one might have imagined. He knew that Claude was
beside the favorite, and he accurately surmised Claude's intent. Therefore,
when he came abreast of the Duchess, who was not in the front row, he
suddenly stopped, turned his head towards her, and remarked, in a perfectly
expressionless tone:
"Mme. de Châteauroux, I have the pleasure of opening the dance with

you to-night."
"HE SUDDENLY STOPPED AND TURNED HIS HEAD TOWARDS

HER"
And before she had time to courtesy her thanks he had passed on again.

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II. Notes to Eighth Edition Users

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4. In touch with data and research: money in a prisoner-of-war camp

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C. Measuring money—the monetary aggregates

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III. The Demand for Money (Sec. 7.3)

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Md/P  L(Y, r  e) (7.3)

Numerical Problem 1 is an empirical exercise calculating velocity from a money-demand

5. Quantity theory of money: Real money demand is proportional to real income

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IV. Asset Market Equilibrium (Sec. 7.4)

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d. Given Y, the goods market equilibrium condition determines r

Numerical Problem 2 is an exercise in calculating the equilibrium interest rate.

V. Money Growth and Inflation (Sec. 7.5)

Numerical Problem 4 gives practice in using elasticities to predict inflation.

B. Application: money growth and inflation in the European countries in transition

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C. The inflation rate and the nominal interest rate

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D. Application: measuring inflation expectations

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 Additional Issues for Classroom Discussion

2. How Will Money’s Role Change in the Future?

3. Should You Buy Indexed Bonds?

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 Answers to Textbook Problems

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So velocity should rise 1.5% over the next year.

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Working with Macroeconomic Data

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"Thus far my memory carries me, monsieur. Continue."

Mme. de Châteauroux noticed this, but her face continued to be as

"Monsieur le Marquis de Coigny and the Comte de Maurepas!"

De Gêvres coughed, but his face expressed none of the disappointment

Mme. de Châteauroux greeted both gentlemen with imperturbable

"Ah!" murmured de Coigny.

"He offered the glove?" asked madame, quietly.

De Gêvres bowed. "In a way, Duchess. He offered to—exchange the

"Oh!" cried Maurepas, angrily.

"Dastardly!" muttered de Coigny.

Mme. de Châteauroux flushed scarlet with anger beneath her powder.

Little Marchon, trained to high gallantry by long experience in haunts of

"Monsieur le Marquis de Mailly-Nesle!" came the announcement.

De Gêvres coughed again; and, amid rather a strained silence, Henri

"Mme. de Coigny has, I believe, no mornings à la toilette," observed

"Her sang-froid is unapproachable," murmured de Gêvres to Maurepas,