2 Money and the Interest Rate Demand for moneyThere are benefit and cost of holding money.The benefit of holding money is the convenience of making payments and do transactions.The opportunity cost of holding money is the nominal interest rate foregone on an alternative asset (e.g. bonds and CDs)Given constant benefit of holding money, the higher the nominal interest rate, the smaller is the quantity of money demanded.Downward-sloping demand curve for money
3 Money and the Interest Rate (Continued) Shifts in the demand for money curveChanges in the price levelChanges in real GDPChanges in financial technologySupply of moneyFixed (vertical curve) at a given point of timeThe supply of and demand for money will determine the equilibrium nominal interest rate.
4 Money and the Interest Rate (Continued) Nominal interest rateNominal interest rate = real interest rate + inflation rateThe interest rate and bond price move in opposite directionsThe Fed can affect the nominal interest rateDiscount rate federal funds rate prime rateChange in money supply change in the nominal interest rate
5 Money and Inflation Equation of Exchange Quantity Theory of Money M V = P Y (or Q)Velocity of money: the average number of times money spent on purchase of final productsQuantity Theory of MoneyVelocity (V) and aggregate output (Y or Q) are unaffected by a change in money supplyA change in money supply (M) will result in a proportional change in the price level (P)
6 Money and Inflation Continued Short-run vs. long-runIn the short-run, the money supply increase causes a fall in the nominal interest rate.However, in the long–run, the money supply increase also results in the higher price level, causing increase in the demand for money.So, the nominal interest rate returns to its long-run equilibrium level.
7 Monetarism A school of economic thought founded by Milton Friedman Modern version of the quantity theoryRule-based money supply rather than discretionary monetary policyIncrease money supply at a steady rate equal to or slightly larger than the long run growth in outputAt 3% or slightly higher
8 Effects and Costs of Inflation Inflation is a tax: transfer of resources from the private sector to governmentInefficient use of time and resourcesConfusion and uncertainty discourage savings and investment decrease in output and slowdown in economic growthThe cost of inflation depends on the degree of inflationMild inflation (3% or less): smallHyper-inflation: great