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Money, Interest Rate and Inflation Chapter 13

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Money and the Interest Rate Demand for money –There 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

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Money and the Interest Rate (Continued) Shifts in the demand for money curve –Changes in the price level –Changes in real GDP –Changes in financial technology Supply of money –Fixed (vertical curve) at a given point of time The supply of and demand for money will determine the equilibrium nominal interest rate.

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Money and the Interest Rate (Continued) Nominal interest rate –Nominal interest rate = real interest rate + inflation rate –The interest rate and bond price move in opposite directions The Fed can affect the nominal interest rate –Discount rate federal funds rate prime rate –Change in money supply change in the nominal interest rate

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Money and Inflation Equation of Exchange –M V = P Y (or Q) –Velocity of money: the average number of times money spent on purchase of final products Quantity Theory of Money –Velocity (V) and aggregate output (Y or Q) are unaffected by a change in money supply –A change in money supply (M) will result in a proportional change in the price level (P)

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Money and Inflation Continued Short-run vs. long-run –In 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.

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Monetarism A school of economic thought founded by Milton Friedman Modern version of the quantity theory Rule-based money supply rather than discretionary monetary policy –Increase money supply at a steady rate equal to or slightly larger than the long run growth in output –At 3% or slightly higher

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Effects and Costs of Inflation Effects –Inflation is a tax: transfer of resources from the private sector to government –Inefficient use of time and resources –Confusion and uncertainty discourage savings and investment decrease in output and slowdown in economic growth The cost of inflation depends on the degree of inflation –Mild inflation (3% or less): small –Hyper-inflation: great

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