ECN 111 Chapter 13 Lecture Notes

13.1. Money and the Interest Rate

A. The Real Economy
Real factors, which are independent of the price level, determine potential
GDP.
B. The Money Economy
The immediate impact and long-run impact of a change in the quantity of
money are studied in Chapter 13. The intermediate impacts are studied in the
next section of the book.
C. The Demand for Money
The amount of money that households and firms choose to hold is the
quantity of money demanded.
1. Benefit of Holding Money
The marginal benefit of holding money diminishes as the quantity of money
held increases.
2. Opportunity Cost of Holding Money
The opportunity cost of holding money is the interest forgone on an
alternative asset.
3. Opportunity Cost: Nominal Interest is a Real Cost
a. The nominal interest rate is the opportunity cost of holding money.
b. Nominal interest rate = Real interest rate + Inflation rate
4. Other things remaining the same, the higher the nominal interest rate, the
smaller is the quantity of money demanded.
5. The Demand for Money Schedule and Curve
The demand for money is the relationship between the quantity of money
demanded and the nominal interest rate, when all other influences on the
amount of money that people wish to hold remain the same. The demand
curve for money is downward sloping.
D. Changes in the Demand for Money
1. The Price Level
An increase in the price level increases the demand for money. The demand
for money is proportional to the price level—an x percent rise in the price
level brings an x percent increase in the quantity of money demanded at
each nominal interest rate.
2. Real GDP
An increase in real GDP increases the demand for money.
3. Financial Technology
Changes in financial technology can increase the demand for money (ATMs)
or decrease the demand for money (credit cards).
E. Shifts in the Demand for Money Curve
Changes in the price level, real GDP, and financial technology change the
demand for money and shift the demand for money curve.
F. The Nominal Interest Rate
Equilibrium between the demand for money curve and the supply of money
curve determines the equilibrium nominal interest rate in the money market.
1. The supply of money is the relationship between the quantity of money
supplied and the nominal interest rate. The supply of money curve is a
vertical line because the quantity of money supplied is determined by the
actions of the banking system and the Fed.
2. The Interest Rate and Bond Prices Move in Opposite Directions.
 When the price of a bond rises, the interest rate falls; when the price of a
bond falls, the interest rate rises.
3. Interest Rate Adjustment
a. When the interest rate is above its equilibrium level, the quantity of
money supplied exceeds the quantity of money demanded. As people try
to get rid of money, the demand for other financial assets such as bonds
increases, the prices of these assets rise, and the interest rate falls.
b. The converse is true when the interest rate is below its equilibrium level.
G. Changing the Interest Rate
1. The Fed can increase the nominal interest rate by decreasing the quantity
of money.
2. The Fed can lower the nominal interest rate by increasing the quantity of
money.
13.2. Money, the Price Level, and Inflation
A. The Money Market in the Long Run
1. Potential GDP and Financial Technology
In the long run, potential GDP and financial technology are determined by
real factors.
2. The Nominal Interest Rate in the Long Run
a. The nominal interest rate equals the equilibrium real interest rate plus
the inflation rate.
b. The real interest rate is independent of the price level.
3. Money Market Equilibrium in the Long Run
The price level adjusts to make the quantity of money demanded equal to
the quantity supplied.
B. A Change in the Quantity of Money
1. In the short run, an increase in the quantity of money lowers the nominal
interest rate.
2. In the long run, the nominal interest rate returns to its original value.
3. In the long run, the price level rises.
In the long run, other things remaining the same, a given percentage
change in the quantity of money brings an equal percentage change in the
price level.
C. The Quantity Theory of inflation
The quantity theory of money is the proposition that when real GDP equals
potential GDP, an increase in the quantity of money brings an equal
percentage increase in the price level.
1. The Velocity of Circulation and Equation of Exchange
a. The velocity of circulation is the number of times in a year that the
average dollar of money gets used to buy final goods and services. The
velocity of circulation, V is equal to (P  Y)  M, where P is the price level,
and Y is real GDP, and M is the quantity of money.
b. The equation of exchange states that the quantity of money multiplied
by the velocity of circulation equals the price level multiplied by real GDP,
or M  V = P  Y.
2. The Quantity Theory Prediction
Rearrange the equation of exchange as P = M  V  Y. Then, 1) at full
employment GDP equals potential GDP, and 2) the velocity of circulation is
relatively stable and does not change when the quantity of money changes.
So, if M increases with V and Y constant, P must increase by the same
percentage that M increased.
 D. Inflation and the Quantity Theory of Money
In rates of change, or growth rates, the equation of exchange is (Money
growth) + (Velocity growth) = (Inflation) + (Real GDP growth)
1. Changes in the Inflation Rate
a. If potential GDP growth and velocity growth do not change when the
growth rate of the quantity of money changes, then if the growth rate of
the quantity of money increases, the inflation rate rises by the same
amount.
E. Hyperinflation
A hyperinflation is inflation at a rate that exceeds 50 percent a month.
13.3. The Cost of Inflation
A. Tax Costs
1. Inflation is a tax because inflation transfers resources from households and
businesses to government.
2. Inflation Tax, Saving, and Investment
With an income tax levied on nominal interest, the higher the inflation rate,
the lower is the after-tax interest rate received by lenders. With a low after-
tax real interest rate, the incentive to save is weakened, so the supply of
saving and investment decreases.
B. Shoe-leather Costs
The costs that arise from an increase in the velocity of circulation of money
and an increase in the amount of running around that people do to try to
avoid incurring losses from the falling value of money.
C. Confusion Costs
The difficulty in measuring costs and benefits when the price level is unstable.
D. Uncertainty Costs
The increased uncertainty of inflation makes long-term planning difficult and
gives people a shorter-term focus. Investment falls and so the growth rate
falls.
E. How Big Is the Cost of Inflation?
The cost of inflation depends on its rate and its predictability. The higher the
rate, the greater is the cost. And the more unpredictable, the greater is the
cost.