BU.220.610 Chap.4 Money Demand, Interest Rates and Long-Run Inflation
Money Demand, Interest Rates and Long-Run Inflation
Module 4 completes the long-run model by answering the question Module 2 left open: what sets the price level, and therefore inflation? The answer runs through money demand.
Consumers and firms hold currency and bank deposits to pay for goods and services, so the amount of real money they want rises with real income, which drives the volume of transactions, and falls with the nominal interest rate, which is what they give up by holding money instead of an interest-bearing asset.
When the supply of money outruns that demand, too much money chases too few goods and prices rise, as many economies saw after the COVID-19 pandemic. The organising tool is the quantity equation, money times velocity equals the price level times real output. Velocity is how many times the average dollar changes hands in supporting a year's final spending. Read as a definition, the equation always holds.
It becomes a theory once velocity is treated as stable. Then real money demand is proportional to income; in the long run, with output fixed at potential and the money stock set by the central bank, the price level is the only variable left to adjust; and in growth rates, inflation equals money growth minus real output growth.
International comparisons and long averages of US data line up with this prediction, even though year-to-year movements do not. The second tool is the Fisher equation, which splits the nominal interest rate into the real rate and expected inflation. Because the loanable funds market pins down the real rate in the long run, a rise in expected inflation passes one-for-one into nominal rates, the Fisher effect.
Expectations also feed back into prices today: higher expected inflation raises nominal rates, lowers real money demand and so raises the current price level. The chapter then weighs the costs of inflation and deflation. Expected inflation imposes shoeleather costs, menu costs, noise in relative prices and tax distortions.
Unexpected inflation redistributes wealth from lenders to borrowers on fixed contracts, while deflation raises the real burden of existing debt, as Japan's long experience shows. Hyperinflation, usually the result of printing money to pay government bills, destroys money's role as a unit of account. This is why central banks aim for low and predictable inflation and why the Fed interprets price stability as 2% a year.
For a business, the lesson is to know which of its contracts are exposed to the price level, and to read money growth and inflation expectations as signals about future borrowing costs.
What this chapter covers
- 01
Real and nominal money demand
- 02
Velocity and the quantity equation
- 03
Money growth, output growth and inflation
- 04
Nominal and real interest rates and the Fisher effect
- 05
Costs of expected and unexpected inflation
- 06
Deflation and real debt burdens
Worked example · free
Forecast inflation and the nominal rate from money growth
- 2Write the growth form of MV = PY with constant velocity: inflation = money growth minus output growth.
- 2Substitute: 9 minus 3 = 6% inflation.
- 2Apply the Fisher equation with expected inflation equal to 6%: i = 1.5 + 6 = 7.5%.
Key terms
- Velocity of Money
- The number of times the average unit of money is spent on final output in a period, defined as nominal GDP divided by the money stock.
- Quantity Theory
- The theory that, with stable velocity and output at potential, the price level moves in proportion to the money supply.
- Fisher Effect
- The one-for-one response of the nominal interest rate to a change in expected inflation, holding the real rate fixed.
Money Demand, Interest Rates and Long-Run Inflation FAQ
Why does money growth cause inflation only in the long run?
Over long horizons output is fixed by productive capacity and velocity is roughly stable, so extra money can only raise prices. Over a few quarters prices adjust slowly, so extra money can change output and interest rates first.
Who gains when inflation turns out higher than expected?
Borrowers on fixed nominal contracts gain and lenders lose, because repayments are made in dollars that buy less than both sides planned. When inflation undershoots expectations, or prices fall, the transfer runs the other way.
Why do central banks aim for low inflation rather than zero?
The course frames the goal as low and predictable inflation. Stable prices cut shoeleather and menu costs and protect contracts, while falling prices would raise real debt burdens, so the Fed reads price stability as 2% a year rather than a flat price level.
Exam move
Keep the growth form of the quantity equation and the Fisher equation side by side on your formula sheet and practise chaining them: money growth to inflation to the nominal rate. For each cost of inflation, write one business example, since multiple-choice items often describe the cost without naming it.
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