Cap 11

Chapter11
Inflation, Money Growth,

and Interest Rates
Macroeconomics Chapter
Cross-Country Data on Inflation and

Money Growth
Ms = P L(Y, i)
Key equation:
Two possible reasons of inflation:

Decrease
Increase
of real demand for money

of money supply

Money Growth
Inflation rates and money growth

rates for 82 countries from 1960 to
2000.
We measure the price level, P, by
the consumer price index (CPI). We
use the CPI, rather than the GDP
deflator, because of data availability.

Money Growth
Highlights
The
inflation rate was greater than 0

for all countries from 1960 to 2000
The growth rate of nominal currency
was greater than 0 for all countries
from 1960 to 2000.
There is a broad cross-sectional range
for the inflation rates and the growth
rates of money.

Money Growth
Highlights
The
median inflation rate from 1960 to

2000 was 8.3% per year, with 30
countries exceeding 10%.
For the growth rate of nominal
currency, the median was 11.6% per
year, with 50 above 10%

Money Growth
Highlights
In
most countries, the growth rate of

nominal currency, M, exceeded the
growth rate of prices.
For a country that has a high inflation
rate in one period to have a high
inflation rate in another period.
Strong positive association between the
inflation rate and the growth rate of
nominal currency.

Money Growth
10

Money Growth
One lesson from the cross-country data is

that, to understand inflation, we have to
include money growth as a central part of
the analysis.
Milton
Friedmans famous dictum:
Inflation is always and

everywhere a monetary
phenomenon.
11
Inflation and Interest Rates
Actual and Expected Inflation

Let
be the inflation rate. The inflation

rate from year 1 to year 2, 1, is the
ratio of the change in the price level to
the initial price level.
1 = ( P2 P1)/ P1
1
= P1/ P1
12

1
= ( P2 P1)/ P1
= P1/ P1
P1 = P2 P1
P2
= ( 1 +1) P1
13

Since
the future is unknown,

households have to form forecasts or
expectations of inflation.
Denote by e1 the expectation of the
inflation rate 1.
The actual inflation rate, 1, will usually
deviate from its expectation, e1, and
the forecast erroror unexpected
inflationwill be nonzero.
14

Households
try to keep the errors as

small as possible. Therefore, they use
available information on past inflation
and other variables to avoid systematic
mistakes.
Expectations formed this way are called
rational expectations.
15
Real and Nominal Interest Rates

The
dollar value of assets held as bonds

rises over the year by the factor 1 + i1.
The interest rate i1 is the dollar or
nominal interest rate because i1
determines the change over time in the
nominal value of assets held as bonds.
16
17

The
Real interest rate to be the rate

at which the real value of assets held
as bonds changes over time.
dollar assets in year2 =
( dollar assets in year1)(1+ i1)
P2
= P1 ( 1 + 1)
18
(dollar assets in year2/P2 )=

(dollar assets in year1/P1)
(1+i1)/(1+1)
real assets in year2 =

(real assets in year1) (1+i1)/(1+1)
19

Since
the real interest rate, denoted by

r1, is the rate at which assets held as
bonds change in real value:
(1+r1)
= (1+i1)/(1+1)
20

r1
= i1 1 r11
the cross term, r1 1, which tends to be
small;
real interest rate= nominal interest

rate inflation rate
r1 = i1 1
21
Fisher Equation
i
= r +
Fisher Effect
22
The Real Interest Rate and

Intertemporal Substitution
When
the inflation rate, , is not zero,

it is the real interest rate, r, rather than
the nominal rate, i, that matters for
intertemporal substitution.
23
Actual and Expected Real Interest

Rates
The
expected inflation rate determines

the expected real interest rate, ret
re t
= it et
expected real interest rate= nominal interest rate

expected inflation rate
24
Measuring expected inflation
Ask a sample of people about their expectations.
Use the hypothesis of rational expectations,

which says that expectations correspond to
optimal forecasts, given the available
information. Then use statistical techniques to
gauge these optimal forecasts.
Use market data to infer expectations of inflation
25

Measuring
expected inflation
Livingston Survey
Ask a sample of people 50

economists about their expectations.
26
27
28

Measuring
expected inflation
Indexed bonds, real interest rates, and

expected inflation rates
Indexed government bonds, which adjust

nominal payouts of interest and principal
for changes in consumer-price indexes.
These bonds guarantee the real interest
rate over the maturity of each issue.
29
30
31
Interest Rates on Money

real
interest rate on money=

nominal interest rate on money t
real
interest rate on money = t
32
Inflation in the Equilibrium BusinessCycle Model
Goals
To
see how inflation affects our

conclusions about the determination of
real variables, including real GDP,
consumption and investment,
quantities of labor and capital services,
the real wage rate, and the real rental
price.
To understand the causes of inflation.
33
Assume fully anticipated inflation,

so that the inflation rate, t, equals
the expected rate, et .
Extend the equilibrium businesscycle model to allow for money

growth.
34
Assume the government prints new

currency and gives it to people.
They
receive a transfer payment from

the government.
The payments are lump-sum
transfers, meaning that the amount
received is independent of how much
the household consumes and works,
how much money the household holds,
and so on.
35
Intertemporal-Substitution Effects
The
expected real interest rate, ret , has

intertemporal-substitution effects on
consumption and labor supply.
Therefore, for given it, a change in t
will have these intertemporalsubstitution effects.
36
Bonds and Capital

i
= (R/P) ()
Replace
the nominal interest rate on

bonds, i, by the real rate, r,
= (R/P) ()
37
Interest Rates and the Demand for Money
The tradeoff between earning assets and

holding money is
( i ) () = i
Therefore, the nominal interest rate, i, still

determines the cost of holding money rather
than earning assets. We can therefore still
describe real money demand by the function
Md / P = L( Y, i )
38
Interest Rates and the Demand for

Money
It
is the real interest rate, r, that has

intertemporal-substitution effects on
consumption and labor supply.
It is the nominal interest, i, that
influences the real demand for money,
Md/P.
39
40
41
Inflation and the Real Economy

A
change in the inflation rate, , does

not shift the demand or supply curve
for capital services. Therefore, ( R/P) *
and (K) * do not change.
A change in the inflation rate, , does
not shift the demand or supply curve
for labor. Therefore, ( w/ P) * and L*
do not change.
42

Real
GDP, Y, is determined by the

production function
Y= A F( K, L)
We
conclude that a change in does

not influence real GDP, Y.
43

The real rental price, R/P, and the capital
utilization rate, , determine the real rate
of return from owning capital, (R/P)
(), and therefore the real interest rate,
r,
r = ( R/ P) () .
Since R/P and are unchanged, we find
that a change in the inflation rate, ,
does not affect the real interest rate, r.
44

If
we continue to ignore income effects

from inflation, , we know that C does
not change.
Since
Y is fixed, we conclude that I

does not change.
45
We have found that the time paths of

money growth and inflation do not affect a
group of real variables.
This group comprises real GDP, Y; inputs of

labor and capital services, L and K;
consumption and investment, C and I; the
real wage rate, w/P; the real rental price,
R/P; and the real interest rate, r.
The neutrality of money apply, as an

approximation, to the entire path of money
growth.
46
Money Growth, Inflation, and the

Nominal Interest Rate
Analyze
how the time path of the

nominal quantity of money, Mt,
determines the time path of the price
level, Pt, and, hence, the inflation
rate,t.
We
also assume for now that Yt and rt

are constant over time.
47

Mt
t
=Mt+1Mt
= Mt/Mt
Mt+1
= (1+t)Mt
= Pt/ Pt
= (Pt+1Pt)/Pt
Pt+1
= (1+t)Pt
48

Show
that
When Mt grows steadily at the rate , the

price level, Pt, will also grow steadily at
the rate .
49

The
real quantity of money demanded,

L(Y, i), does not vary over time.
real GDP, Y, is fixed.
i = r+
i = r+
Since we assumed that r and are fixed, i is

unchanging. Since Y and i are fixed, we have
verified that the real quantity of money
demanded, L(Y, i), is unchanging.
50

The
level of real money demanded, L(Y,

i), equals the unchanging level of real
money balances, Mt/Pt .
L(Y, i) and Mt/Pt are both fixed over time.

Therefore, if the levels of the two
variables are equal in the current year,
year 1,they will remain equal in every
future year.
51

Determination
t,
of price level:
P1 = M1 / L( Y, i)
is the constant = .
52

The
inflation rate, , equals the

unchanging growth rate of money, .
Real money balances, Mt/Pt, are fixed
over time.
The nominal interest rate, i, equals r +
, where r is the unchanging real
interest rate.
53

The
real quantity of money demanded,

L(Y, i), is fixed over time, where Y is
the unchanging real GDP.
P1
= M1 / L( Y, i)
54
A Trend in the Real Demand for

Money
Assume
that L(Y, i) grows steadily at

the constant rate .
This growth might reflect long-term

growth of real GDP
55

Money
Real
money balances, Mt/Pt, increase

because of growth in the numerator, Mt,
at the rate , but decrease because of
growth in the denominator, Pt, at the
rate .
growth
rate of Mt/ Pt =
56

Money
If
L(Y, i) grows at rate , Mt/Pt must

also grow at rate .
57
58
A Shift in the Money Growth Rate

Suppose
that the monetary authority

raises the money growth rate from to
in year T.
59
60
A Shift in the Money Growth Rate

i
i =
Mt/Pt is constant before year T.
Mt/Pt
is constant after year T.
Mt/Pt
after year T is lower than that

before year T (because of the rise in
the nominal interest rate from i to i).
61
Government Revenue from Printing

Money
Have
assumed, thus far, that the

monetary authority prints new money
(currency) and gives it to households as
transfer payments.
Governments
get revenue from

printing money and can use this
revenue to pay for a variety of
expenditures.
62

Money
Nominal
revenue from printing money
= Mt+1Mt = Mt
Real

= Mt/ Pt+1
Real money growth rate

t = Mt/ Mt
63

Money
Real
= t( Mt /Pt+1)
t( Mt / Pt )
= (money growth rate) (level of real
money balances)
64
65

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Chapter11

Inflation, Money Growth,

Cross-Country Data on Inflation and

Two possible reasons of inflation:

of real demand for money

Cross-Country Data on Inflation and

Inflation rates and money growth

Cross-Country Data on Inflation and

inflation rate was greater than 0

Cross-Country Data on Inflation and

median inflation rate from 1960 to

Cross-Country Data on Inflation and

most countries, the growth rate of

Cross-Country Data on Inflation and

Cross-Country Data on Inflation and

One lesson from the cross-country data is

Friedmans famous dictum:

Inflation is always and

Inflation and Interest Rates

Actual and Expected Inflation

be the inflation rate. The inflation

Inflation and Interest Rates

Actual and Expected Inflation

Inflation and Interest Rates

Actual and Expected Inflation

the future is unknown,

Inflation and Interest Rates

Actual and Expected Inflation

try to keep the errors as

Inflation and Interest Rates

Real and Nominal Interest Rates

dollar value of assets held as bonds

Inflation and Interest Rates

Inflation and Interest Rates

Real and Nominal Interest Rates

Real interest rate to be the rate

Inflation and Interest Rates

Real and Nominal Interest Rates

(dollar assets in year2/P2 )=

real assets in year2 =

Inflation and Interest Rates

Real and Nominal Interest Rates

the real interest rate, denoted by

Inflation and Interest Rates

Real and Nominal Interest Rates

real interest rate= nominal interest

Inflation and Interest Rates

Inflation and Interest Rates

The Real Interest Rate and

the inflation rate, , is not zero,

Inflation and Interest Rates

Actual and Expected Real Interest

expected inflation rate determines

expected real interest rate= nominal interest rate

Inflation and Interest Rates

Measuring expected inflation

Ask a sample of people about their expectations.

Use the hypothesis of rational expectations,

Use market data to infer expectations of inflation

Inflation and Interest Rates

Ask a sample of people 50

Inflation and Interest Rates

Inflation and Interest Rates