Problem Set 3: Money and Ination

1. The quantity theory of money (Fisher 1911) asserts that money demand is proportional to
nominal income, i.e. M d = kP Y , with k constant.
(a) What is the velocity of circulation of money according to this specication?
Answer. Velocity is dened as the ratio between nominal income and money, i.e.
P Y =M . In this specication this is equal to 1=k. As k is constant, velocity is also
constant.
(b) Modern theory of money demand considers the nominal interest rate as a further determinant of money demand. Specically: M d = P L(Y; i), with L increasing in Y and
decreasing in i. Give intuition for why L decreases with i.
Answer. L decreases with i because the nominal interest rate represents the opportunity cost of holding money. The higher the interest rate, the higher the loss of nancial
income that could be earned on assets that are imperfect substitutes to money.
(c) Consider the further assumption L(Y; i) = Y `(i), with ` decreasing in i: Is money
demand still proportional to nominal income, as in the original quantity theory?
Answer. Now M d = P Y `(i). Money demand is no longer proportional to nominal
income, as `(i) varies with the interest rate.
(d) Obtain an expression for velocity in this new specication. How would you expect
velocity to change with an increase in i? Provide economic intuition for this eect. How
does this result dier from the original quantity theory?
Answer. Velocity = P Y =M = 1=`(i). As `0 (i) < 0, velocity increases with the interest
rate. When the interest rate is relatively high, the opportunity cost of holding money is
high, and thus individuals - other things equal - tend to get rid of their money holdings
faster. This raises velocity.
(e) Figure 2 shows the evolution of the M=(P Y ) ratio and the nominal interest rate in the
US since 1960. What can you say about the empirical relationship between velocity and
the nominal interest rate?
Answer. The M=(P Y ) ratio is the inverse of velocity. Thus the gure shows that
velocity was indeed positively correlated to the interest rate until about the early 1980s.
This is in line with the predictions of theory (see answer to part (d)). But between the
early 1980s and the mid-1990s, the interest has fallen considerably, while velocity has
remained roughly constant. If we expect velocity to fall with the interest rate, while it
has remained roughly constant, one possible interpretation is that there is some other
variable in the background that prevents velocity from falling. It has been suggested that
this variable is the extent of technological progress in nancial markets. In particular,
the massive introduction of credit cards since the early 1980s implies that individuals
do not need to hold money while making credit card purchases, because they are paying
with credit. They would only need to hold money at the end of the month when the
credit card bill is settled. This tends to lower money demand at given nominal income,
thus it tends to raise velocity. It may be the case that the opposite eects of lower
interest rates and the introduction of credit cards on velocity have roughly oset each
other during the 1980-1995 period, and velocity has remained roughly constant.
2. Seigniorage is the revenue raised by the government through the creation of money. In real
terms: seigniorage S =
M=P: In other words, by printing a new amount of money
M , the
government can purchase
M=P units of goods and services.
6

Figure 2: The money to nominal income ratio and the nominal interest rate in the US. Source:
Blanchard, Macroeconomics.

(a) Multiply and divide this expression by M to obtain seigniorage as a function of real
money balances in the economy.
Answer. S =
M=P = (
M=M )  (M=P )
(b) Now consider the following money demand function: M d =P = L(Y; i) = L(Y; r +  e ) =
Y [1  (r +  e )]: Assuming equilibrium in the money market (M d = M ), derive an
expression for seigniorage, S =
M=P: Assuming the following values: Y = 250, r =
0:05,  e = 0:1, obtain the value of seigniorage for a rate of money growth of (i) 25%, (ii)
50%, (iii) 75%.
Answer. S = (
M=M )  (M=P ) = (
M=M )  Y [1  (r +  e )] = (
M=M )  250[1 
(0:05 + 0:1)]. With the values given, seigniorage is equal to (i) 53.125, (ii) 106.25, (iii)
159.375, i.e. it is monotonically increasing in the rate of money growth.
(c) Now assume expected ination is equal to the rate of money growth, while Y , r, and a
stay the same. Obtain again the value of seigniorage for a rate of money growth of (i)
25%, (ii) 50%, (iii) 75%. Why are your answers dierent from those obtained at point
(b)?
Answer. S = (
M=M )  Y [1  (r +
M=M )]: With the values given, seigniorage
is equal to (i) 43.75, (ii) 56.25, (iii) 37.5, i.e. it is no longer monotonically increasing
in the rate of money growth. This happens because we are now taking into account
that expected ination is endogenous, and follows the rate of money growth (unlike at
point (c), where we assumed expected ination was exogenous). When  e =
M=M ,
an increase in
M=M reduces real money balances M=P , and thus what happens to
seigniorage S = (
M=M )  (M=P ) is ambiguous. In particular, seigniorage increases for
values of
M=M below a certain threshold, and decreases afterwards. With the values

given in this exercise, such threshold is the solution to




M

M
 250 1  0:05 
:
max
M
M=M M
The derivative of the above expression with respect to
M=M is equal to 237:5 
500
M=M . Setting this equal to zero gives the value of
M=M that maximizes seigniorage:
M=M = 47:5%:
(d) What can we learn about the use of money growth as a means of raising revenue? Why
is money growth referred to as the ination tax in this case? Can you see similarities
with the relationship between the income tax rate and the tax revenue?
Answer. We have learned that the government cannot hope to raise the seigniorage
revenue by indenitely raising the rate of money growth, because this in turn reduces
real money balances. We can think of the rate of money growth as an ination tax, and
real money balances as the tax base: as an increase in the ination tax erodes the size
of the tax base, eventually the erosion of the tax base will outweight the increase in the
ination tax and the total seigniorage revenue falls. In general there will be a level of
the ination tax that maximizes the seigniorage revenue. This is also what happens to
scal revenue when one considers the relationship between the income tax rate and the
total tax revenue. Such relationship is known as the Laer curve.
3. Suppose you are advising a small country on whether to print its own money or to use the
money of its larger neighbor (e.g. the Euro). What are the costs and benets of a national
money? Does the relative political stability of the small country and of the Euro Area play
any role in this decision?
Answer. When a small country adopts the money of its neighbor (Euro) instead of printing
its own money it bears the cost of losing monetary policy as an independent policy instrument. But this has the advantage of importing monetary discipline and in particular ruling
out seigniorage and hyperination - provided of course that the ECB is independent and
committed to low and stable ination. The benets from this practice obviously decrease in
the political stability (and central bank independence) of the small country relative to the
Euro Area. Recent example: Bulgaria announced to peg the national currency to the Euro
until the country enters the Euro zone.