After completing this chapter, students will be able to: See why some countries print so much money that they experience hyperinflation, examine how the nominal interest rate responds to the inflation rate, consider the various costs that inflation imposes on society. | Review of the previous lecture Money the stock of assets used for transactions serves as a medium of exchange, store of value, and unit of account. Commodity money has intrinsic value, fiat money does not. Central bank controls money supply. Quantity theory of money assumption: velocity is stable conclusion: the money growth rate determines the inflation rate. Lecture 20 Money and Inflation- II Instructor: Abbas Course code: ECO 400 Lecture Outline Seigniorage Fischer effect Money demand and the nominal interest rate Inflation Seigniorage To spend more without raising taxes or selling bonds, the govt can print money. The “revenue” raised from printing money is called seigniorage (pronounced SEEN-your-ige) The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. Inflation and interest rates Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i The Fisher | Review of the previous lecture Money the stock of assets used for transactions serves as a medium of exchange, store of value, and unit of account. Commodity money has intrinsic value, fiat money does not. Central bank controls money supply. Quantity theory of money assumption: velocity is stable conclusion: the money growth rate determines the inflation rate. Lecture 20 Money and Inflation- II Instructor: Abbas Course code: ECO 400 Lecture Outline Seigniorage Fischer effect Money demand and the nominal interest rate Inflation Seigniorage To spend more without raising taxes or selling bonds, the govt can print money. The “revenue” raised from printing money is called seigniorage (pronounced SEEN-your-ige) The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. Inflation and interest rates Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i The Fisher Effect The Fisher equation: i = r + S = I determines r . Hence, an increase in causes an equal increase in i. This one-for-one relationship is called the Fisher effect. Two real interest rates = actual inflation rate (not known until after it has occurred) e = expected inflation rate i – e = ex ante real interest rate: what people expect at the time they buy a bond or take out a loan i – = ex post real interest rate: what people actually end up earning on their bond or paying on their loan Money demand and the nominal interest rate The Quantity Theory of Money assumes that the demand for real money balances depends only on real income Y. We now consider another determinant of money demand: the nominal interest rate. The nominal interest rate i is the opportunity cost of holding money (instead of bonds or other interest-earning assets). Hence, i in money demand. (M/P )d = real money demand, depends negatively on i i is the opp. cost of holding money positively on Y .
