17:30

The Linkages among Money, Prices, and

Interest Rates
MACROECONOMICS
Session – 4-5

Role of Money:
(Prices, Inflation, Interest Rate - inter-links)

Learning Objectives
• What is role of money? – Concept, definition and
impacts
• How money supply affects the economy?
Measuring Quantity of Money – stock of assets used for
transaction
• What are the factors affect money market –
money supply and demand? – control of money
supply, monetary policy
• How quantity of money determines price level
and inflation? – relation between money supply (M),
prices (P), inflation (), interest rate (i) & income or
output (Y) or AD
• How inflation affects interest rate and the
economy as a whole?
Connection between
Money & Prices
• Price = amount of money (M) required to
buy a good. (P = rate at which money is
exchanged for goods & services)
• Inflation rate = the percentage increase
in the average level of prices (P).
• Because prices (P) are defined in terms of
money, we need to consider the nature of
money, the supply of money, and how it is
controlled.

Money: Definition Money: Functions

• medium of exchange: we use it to buy
Money is the stock goods and services
of assets that can be readily used to • store of value: transfers purchasing
make transactions. power from the present to the future -
money retains its value over time
• unit of account: the common unit by
which everyone measures prices and
values

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Why Do We Need Money?

How Stable Is The Money Demand Function?
 Transaction demand will depend on income and 
the frequency with which people are paid and to a 
 There are three motives for holding money:
lesser extent on interest rates
 Transaction motive  Precautionary demand will depend on income 
 Precautionary motive and interest rates

 Speculative motive  Speculative demand will depend on expectations
about interest rates, exchange rates and inflation
 In general, demand for money is an increasing 
function of income and a decreasing function of   In an era of financial sophistication, uncertainty about 
inflation, exchange rates and inflation demand for money 
interest rate may be hard to predict. Will be susceptible to rumors and 
7 political events. 8

Money: Types Money Supply & Monetary Policy

• Money Supply: is the quantity of money
1. Fiat money available in the economy. – measuring quantity of
– has no intrinsic value money
– example: the paper currency we use • Currency issued by the central bank is
2. Commodity money called ‘high power money’. (RBI)
– has intrinsic value • Monetary policy: is the control over the money
– examples: supply by a country’s central bank. It controls
gold coins, money supply – important role to play in
macroeconomics
• OMO – purchase and sale of Govt. bonds to
increase and decrease money supply (M)

Measures of Money Supply Total Money Supply (M)

symbol assets included

M1= currency with public + chequeable deposits with 
C Currency banks + “other deposits” with RBI
C + demand deposits, travelers’ M2 = M1 + post office saving deposits
M1 checks, other checkable deposits
M3 = M1 + time deposits with banks
M2 M1 + small time deposits, savings deposits,
money market mutual funds, money market M4 = M3 + all post office deposits
deposit accounts
M1 is known as “narrow” money and M3 as “broad” 
M3 M2 + large deposits re-purchase agreements, money.
Eurodollars, others
12

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RBI Measures of Money Supply

Conduct Of Monetary Policy
1. Open Market Operations

Outright  Repo (RBI buys) and 
purchases and  reverse repo (RBI 
sales sells)

2. Bank Rate

3. CRR
4. Selective Credit Controls

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Quantity Theory of Money: Quantity Equation

(How change in quantity of money affects Economy)
Velocity
• basic concept: the rate at which money
circulates
• Quantity of money is related to other economic
variables: Price (P), Income (Y) • definition: the number of times the average
dollar bill changes hands in a given time period
• Quantity Equation: MV = PT
M (money) x V (velocity) = P (Price) x T (Transactions) • example: In 2009,
– Total value of transactions = 500 billion
T = (Nos time goods & services are exchanged for money in a year) – Total money supply = 100 billion
P = price of transaction
PT = Nos of currencies (Rs or dollars) exchanged in a year
– The average dollar is used in five transactions
MV = money used to make transaction or in 2009
• the concept of velocity (V)… rate at which money – So, velocity (V) = 5
circulates in the economy.

Velocity, cont.
Example of Velocity of Money (V) From Transaction (T) to Income (Y)
MV = PY
Example: 120 bags rice are sold in a year at Rs • As nos of Transactions (T) made in the economy is difficult
10/- per bag. So T = 120 bags per year, P = 10/- to measure, We Use nominal GDP as a proxy for total
transactions.

Then PT = 10x120 = Rs 1200/- Now T is replaced by total output or income Y of economy

Then, P Y
V 
where M
Let’s money supply (M) = Rs 100/-,
P = price of output (GDP deflator)
MV = PT or, V = PT/M
Y = quantity of output (real GDP)
or 1200/100 = 12 times per year (each rupee has
changed hands 12 times per year) P Y = value of output (nominal GDP)
Note: ‘T’ and ‘Y’ are related (more the economy produced
more goods are bought and sold)

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The quantity equation Money Demand & the Quantity Equation

• The quantity equation MV = PY
follows from the preceding definition of velocity.
M (money)  V (velocity) = P (price)  Y (income)
• Assume V is constant, then M = PY or Nominal
GDP
• Quantity of Money = what it can buy
• Demand for Money = (transaction, precaution,
speculation motives) f(Y, i)
• M/P = real money balances, the purchasing
power of the money supply

• It is an identity: it holds by definition of the • A simple money demand function: determinants of the
variables. quantity of real money balances people wish to hold
(M/P)d = kY
where, k is a constant shows how much money people
wish to hold for each rupee/dollar of income. (k is
exogenous)

Money Demand & the Quantity Equation
• money demand: (M/P)d = kY
• quantity equation: M V = P Y
• The connection between them: k = 1/V
• When people hold lots of money relative
to their incomes (k is large), or money
changes hands infrequently (when V is small).
Back to the quantity theory of money
• starts with quantity equation
• assumes V is constant & exogenous: V V
Then, quantity equation becomes:
M V  P Y
Note: If ‘V’ is constant, then quantity of Money (M)
determines the monetary value of economy’s
output (PY)

Quantity Theory of Money (M) & its The quantity theory of money:
Links in an Economy: 3. Money (M), Prices (P) & Inflation ()
(how Qty. Thy. Of Money determines Nominal GDP or PY)
• The quantity equation changes or in growth rates:
1. Inter-links of : GDP (Y), Money Supply (M), M V P Y
  
Prices (P) Inflation () and Interest rate (i) M V P Y
2. How the price level is determined: M V  P Y The quantity theory of money assumes
V
– Nominal GDP (PY) determined by Qty. Theory of Money V is constant, so = 0.
V
– With V constant, the money supply (M)determines nominal
• As V (by assumption) and real GDP (by supply of L, K) are
GDP (M = P Y ). constant, Price level (P) is proportional to Money supply (M)
– Real GDP (Y) is independent of M & V and determined by • Hence, the central Bank which controls money supply has
control over inflation.
the economy’s supplies of K and L (Y= L,K).
• If (M) increases, (P) also increases leading to rise in
– Price level (P) is jointly determined by nominal GDP (PY) & inflation ()
Real GDP (Y) or (P = (nominal GDP)/(real GDP).

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Quantity Theory of Money:

3. GDP (Y), Money (M), Prices (P) & Inflation ()
Quantity Theory of Money :
Summary & Implication
P
 (inflation rate):  
P
The result from the M Y P • If ‘V’ is constant, % change in ‘M’ = % change in

preceding slide: M P Y ‘P’ and ‘Y’ or PY = % change in nominal GPD
M Y
Solve this result for :   
M Y
• Normal economic growth requires a certain amount of money supply • If ‘Y’ is constant, % change in ‘M’ = % in ‘P’
growth - to facilitate the growth in transactions. (real GDP is fixed due to fixed in K, L, T as we assumed)
• Money growth in excess of this amount leads to inflation. Growth of
Money Supply determines rate of inflation ()
• Y/Y depends on growth in the factors of production (L, K, T) - (all of • So, % change in ‘P’ determines % change
which we take/assume as given, for now). in inflation (), or growth of ‘M’ will
• Hence, the Quantity Theory predicts a one-for-one relation between
changes in money growth rate and changes in the inflation rate.
determine inflation ()

4. Inflation () & Interest Rates (i) Links Inflation and Nominal Interest Rates Across Countries
• Nominal interest rate (i): not adjusted for inflation
• Real interest rate (r): adjusted for inflation Nominal
so, r = i -  interest rate 100
(percent, Georgia Romania
or, i = r +  logarithmic Zimbabwe
=i-r
Turkey
or scale) Brazil

• So, an increase in  causes an equal increase in i. Israel

• This relationship is called the Fisher effect. 10

The Fisher equation: i = r +  Kenya

U.S.
Rise in growth of Money (M) causes increase in inflation() Ethiopia
Germany
1
causes increase in nominal interest rate (i) 1 10 100 1000
Inflation rate
(percent, logarithmic scale)

Money Demand (M/P)d &

Nominal interest rate (i) The money demand function
(M P )d  L (i , Y )
• the demand for real money balances (M/P)d
depends income (Y) (M/P)d = real money demand, depends
• Another determinant of money demand: – negatively on i
the nominal interest rate, i. (i is the opportunity cost of holding money)
or the opportunity cost of holding money – positively on Y
(instead of buying bonds or other interest- higher Y  more spending
earning assets).  so, need more money
• Hence, i   in money demand (M/P)d .
(“L” is used for the money demand function
because money is the most liquid asset.)

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The money demand function Equilibrium

(M P )  L (i , Y )
d
M
 L (r  E  , Y )
 L (r  E  , Y ) P
The supply of real
money balances Real money
When people are deciding whether to hold money or bonds, demand
they don’t know what inflation will turn out to be.

Hence, the nominal interest rate (i) relevant for money

demand is r + E.
r + E. = i
Or, sum of real interest rate and expected inflation

Two Real Interest Rates What determines what

Notation: M
•  = actual inflation rate  L (r  E  , Y )
P
(not known until it has occurred)
• E = expected inflation rate variable how determined (in the long run)
M exogenous (the central bank)
Two real interest rates:
r adjusts to ensure S = I (discussed before)
• r = i – E = ex ante real interest rate:
the real interest rate people expect at the time they buy a Y
Y  F (K , L )
bond or take out a loan P adjusts to ensure
• r = i –  = ex post real interest rate: the real interest M
rate actually realized  L (i , Y )
P
• So, i = r + E

How P responds to M What about expected inflation?

M • Over the long run, people don’t consistently over or under-
 L (r  E  , Y ) forecast inflation,
P so E =  on average.
• In the short run, E may change when people get new
• For given values of r, Y, and E , information.
Example: The central bank announces it will
a change in M causes P to change by increase M next year. People will expect next year’s
P to be higher,
the same percentage – just like in the so E rises.
quantity theory of money. • This affects P now, even though M hasn’t changed yet….

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How P responds to E Demand for Money & Expectations

M
 L (r  E  , Y ) • Money demand is based on three key
P Expectations - interest rates (i), exchange rates
(Re) and inflation (E)
• For given values of r, Y, and M , • Era of uncertainty expectations are hard to predict
 E    i (the Fisher effect) – susceptible to rumor & political events
  M P 
d
• Demand for money (M/P)d for inversely related to
expected exchange rate (Re) and interest rates
  P to make M P  fall but directly to inflation and level of income (Y).
to re-establish eq'm • Predictability of the relationships to optimum
accuracy is important

Issues Money Supply (open economy)

Impossible Trinity

In a globally integrated world, a country:
Ms             P  P
a. Can not stabilize exchange rates (Re), if it wants to 
Ms i follow an independent monetary policy (P & i)
b. Can not follow an independent monetary policy (P 
Ms Re
& i), if it wants to stabilize the exchange rate (Re)
c. Can not have openness in international finance 
Open Economy: Cannot Stabilize Exchange rate (Re), price  (Re), if it wants to stabilize both (P & i)
(P) and interest rate (i) simultaneously – Impossible Trinity
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Hyperinflation: What causes ? Hyperinflation

• Hyperinflation
• Hyperinflation is caused by excessive – is caused by excessive money supply growth:
money supply growth: – When the central bank prints money, the price level
• When the central bank prints money, the rises.
– If it prints money rapidly enough, the result is
price level rises. hyperinflation.
• If it prints money rapidly enough, the result • Common definition:   50% per month
is hyperinflation.
• Money ceases to function as a store of value, and may
not serve its other functions (unit of account, medium of
exchange).
• People may conduct transactions with barter or a stable
foreign currency.

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A few examples of hyperinflation Why governments create

country period
CPI Inflation M2 Growth hyperinflation
% per year % per year
Israel 1983-85 338% 305% • When a government cannot raise taxes or
Brazil 1987-94 1256% 1451% sell bonds, it must finance spending
Bolivia 1983-86 1818% 1727% increases by printing money.
Ukraine 1992-94 2089% 1029% • In theory, the solution to hyperinflation is
Argentina 1988-90 2671% 1583% simple: stop printing money.
Dem. Republic
1990-96 3039% 2373%
• In the real world, this requires drastic and
of Congo / Zaire painful fiscal restraint.
Angola 1995-96 4145% 4106%
Peru 1988-90 5050% 3517%
Zimbabwe 2005-07 5316% 9914%

Summary
Money
– def: the stock of assets used for transactions
– functions: medium of exchange, store of value,
unit of account
– types: commodity money (has intrinsic value),
fiat money (no intrinsic value)
– money supply controlled by central bank
Quantity theory of money assumes velocity is stable,
concludes that the money growth rate determines the
inflation rate.
Summary
Nominal interest rate
– equals real interest rate + inflation rate
– the opp. cost of holding money
– Fisher effect: Nominal interest rate moves
one-for-one w/ expected inflation.
Money demand
– depends only on income in the Quantity Theory
– also depends on the nominal interest rate
– if so, then changes in expected inflation affect the
current price level.

The Linkages among Money, Prices, and

Interest Rates