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MacroeconomicsChapter11,1,Inflation,MoneyGrowth,andInterestRates,Chapter11,MacroeconomicsChapter11,2,Cross-CountryDataonInflationandMoneyGrowth,Keyequation:Ms=PL(Y,i)Twopossiblereasonsofinflation:DecreaseofrealdemandformoneyIncreaseofmoneysupply,MacroeconomicsChapter11,3,Cross-CountryDataonInflationandMoneyGrowth,Inflationratesandmoneygrowthratesfor82countriesfrom1960to2000.Wemeasurethepricelevel,P,bytheconsumerpriceindex(CPI).WeusetheCPI,ratherthantheGDPdeflator,becauseofdataavailability.,MacroeconomicsChapter11,4,MacroeconomicsChapter11,5,MacroeconomicsChapter11,6,MacroeconomicsChapter11,7,Cross-CountryDataonInflationandMoneyGrowth,HighlightsTheinflationratewasgreaterthan0forallcountriesfrom1960to2000Thegrowthrateofnominalcurrencywasgreaterthan0forallcountriesfrom1960to2000.Thereisabroadcross-sectionalrangefortheinflationratesandthegrowthratesofmoney.,MacroeconomicsChapter11,8,Cross-CountryDataonInflationandMoneyGrowth,HighlightsThemedianinflationratefrom1960to2000was8.3%peryear,with30countriesexceeding10%.Forthegrowthrateofnominalcurrency,themedianwas11.6%peryear,with50above10%,MacroeconomicsChapter11,9,Cross-CountryDataonInflationandMoneyGrowth,HighlightsInmostcountries,thegrowthrateofnominalcurrency,M,exceededthegrowthrateofprices.Foracountrythathasahighinflationrateinoneperiodtohaveahighinflationrateinanotherperiod.Strongpositiveassociationbetweentheinflationrateandthegrowthrateofnominalcurrency.,MacroeconomicsChapter11,10,Cross-CountryDataonInflationandMoneyGrowth,MacroeconomicsChapter11,11,Cross-CountryDataonInflationandMoneyGrowth,Onelessonfromthecross-countrydataisthat,tounderstandinflation,wehavetoincludemoneygrowthasacentralpartoftheanalysis.MiltonFriedmansfamousdictum:“Inflationisalwaysandeverywhereamonetaryphenomenon.”,MacroeconomicsChapter11,12,InflationandInterestRates,ActualandExpectedInflationLetbetheinflationrate.Theinflationratefromyear1toyear2,1,istheratioofthechangeinthepriceleveltotheinitialpricelevel.1=(P2P1)/P11=P1/P1,MacroeconomicsChapter11,13,InflationandInterestRates,ActualandExpectedInflation1=(P2P1)/P11=P1/P11P1=P2P1P2=(1+1)P1,MacroeconomicsChapter11,14,InflationandInterestRates,ActualandExpectedInflationSincethefutureisunknown,householdshavetoformforecastsorexpectationsofinflation.Denotebye1theexpectationoftheinflationrate1.Theactualinflationrate,1,willusuallydeviatefromitsexpectation,e1,andtheforecasterrororunexpectedinflationwillbenonzero.,MacroeconomicsChapter11,15,InflationandInterestRates,ActualandExpectedInflationHouseholdstrytokeeptheerrorsassmallaspossible.Therefore,theyuseavailableinformationonpastinflationandothervariablestoavoidsystematicmistakes.Expectationsformedthiswayarecalledrationalexpectations.,MacroeconomicsChapter11,16,InflationandInterestRates,RealandNominalInterestRatesThedollarvalueofassetsheldasbondsrisesovertheyearbythefactor1+i1.Theinterestratei1isthedollarornominalinterestratebecausei1determinesthechangeovertimeinthenominalvalueofassetsheldasbonds.,MacroeconomicsChapter11,17,InflationandInterestRates,MacroeconomicsChapter11,18,InflationandInterestRates,RealandNominalInterestRatesTheRealinterestratetobetherateatwhichtherealvalueofassetsheldasbondschangesovertime.dollarassetsinyear2=(dollarassetsinyear1)(1+i1)P2=P1(1+1),MacroeconomicsChapter11,19,InflationandInterestRates,RealandNominalInterestRates(dollarassetsinyear2/P2)=(dollarassetsinyear1/P1)(1+i1)/(1+1)realassetsinyear2=(realassetsinyear1)(1+i1)/(1+1),MacroeconomicsChapter11,20,InflationandInterestRates,RealandNominalInterestRatesSincetherealinterestrate,denotedbyr1,istherateatwhichassetsheldasbondschangeinrealvalue:(1+r1)=(1+i1)/(1+1),MacroeconomicsChapter11,21,InflationandInterestRates,RealandNominalInterestRatesr1=i11r11thecrossterm,r11,whichtendstobesmall;realinterestrate=nominalinterestrateinflationrater1=i11,MacroeconomicsChapter11,22,InflationandInterestRates,FisherEquationi=r+FisherEffecti,MacroeconomicsChapter11,23,InflationandInterestRates,TheRealInterestRateandIntertemporalSubstitutionWhentheinflationrate,isnotzero,itistherealinterestrate,r,ratherthanthenominalrate,i,thatmattersforintertemporalsubstitution.,MacroeconomicsChapter11,24,InflationandInterestRates,ActualandExpectedRealInterestRatesTheexpectedinflationratedeterminestheexpectedrealinterestrate,retret=itetexpectedrealinterestrate=nominalinterestrateexpectedinflationrate,MacroeconomicsChapter11,25,InflationandInterestRates,MeasuringexpectedinflationAskasampleofpeopleabouttheirexpectations.Usethehypothesisofrationalexpectations,whichsaysthatexpectationscorrespondtooptimalforecasts,giventheavailableinformation.Thenusestatisticaltechniquestogaugetheseoptimalforecasts.Usemarketdatatoinferexpectationsofinflation,MacroeconomicsChapter11,26,InflationandInterestRates,MeasuringexpectedinflationLivingstonSurveyAskasampleofpeople（50economists）abouttheirexpectations.,MacroeconomicsChapter11,27,InflationandInterestRates,MacroeconomicsChapter11,28,InflationandInterestRates,MacroeconomicsChapter11,29,InflationandInterestRates,MeasuringexpectedinflationIndexedbonds,realinterestrates,andexpectedinflationratesIndexedgovernmentbonds,whichadjustnominalpayoutsofinterestandprincipalforchangesinconsumer-priceindexes.Thesebondsguaranteetherealinterestrateoverthematurityofeachissue.,MacroeconomicsChapter11,30,InflationandInterestRates,MacroeconomicsChapter11,31,InflationandInterestRates,MacroeconomicsChapter11,32,InflationandInterestRates,InterestRatesonMoneyrealinterestrateonmoney=nominalinterestrateonmoneytrealinterestrateonmoney=t,MacroeconomicsChapter11,33,InflationintheEquilibriumBusiness-CycleModel,GoalsToseehowinflationaffectsourconclusionsaboutthedeterminationofrealvariables,includingrealGDP,consumptionandinvestment,quantitiesoflaborandcapitalservices,therealwagerate,andtherealrentalprice.Tounderstandthecausesofinflation.,MacroeconomicsChapter11,34,InflationintheEquilibriumBusiness-CycleModel,Assumefullyanticipatedinflation,sothattheinflationrate,t,equalstheexpectedrate,et.Extendtheequilibriumbusiness-cyclemodeltoallowformoneygrowth.,MacroeconomicsChapter11,35,InflationintheEquilibriumBusiness-CycleModel,Assumethegovernmentprintsnewcurrencyandgivesittopeople.Theyreceiveatransferpaymentfromthegovernment.Thepaymentsarelump-sumtransfers,meaningthattheamountreceivedisindependentofhowmuchthehouseholdconsumesandworks,howmuchmoneythehouseholdholds,andsoon.,MacroeconomicsChapter11,36,InflationintheEquilibriumBusiness-CycleModel,Intertemporal-SubstitutionEffectsTheexpectedrealinterestrate,ret,hasintertemporal-substitutioneffectsonconsumptionandlaborsupply.Therefore,forgivenit,achangeintwillhavetheseintertemporal-substitutioneffects.,MacroeconomicsChapter11,37,InflationintheEquilibriumBusiness-CycleModel,BondsandCapitali=(R/P)()Replacethenominalinterestrateonbonds,i,bytherealrate,r,r=(R/P)(),MacroeconomicsChapter11,38,InflationintheEquilibriumBusiness-CycleModel,InterestRatesandtheDemandforMoneyThetradeoffbetweenearningassetsandholdingmoneyis(i)()=iTherefore,thenominalinterestrate,i,stilldeterminesthecostofholdingmoneyratherthanearningassets.WecanthereforestilldescriberealmoneydemandbythefunctionMd/P=L(Y,i),MacroeconomicsChapter11,39,InflationintheEquilibriumBusiness-CycleModel,InterestRatesandtheDemandforMoneyItistherealinterestrate,r,thathasintertemporal-substitutioneffectsonconsumptionandlaborsupply.Itisthenominalinterest,i,thatinfluencestherealdemandformoney,Md/P.,MacroeconomicsChapter11,40,InflationintheEquilibriumBusiness-CycleModel,MacroeconomicsChapter11,41,InflationintheEquilibriumBusiness-CycleModel,MacroeconomicsChapter11,42,InflationintheEquilibriumBusiness-CycleModel,InflationandtheRealEconomyAchangeintheinflationrate,doesnotshiftthedemandorsupplycurveforcapitalservices.Therefore,(R/P)*and(K)*donotchange.Achangeintheinflationrate,doesnotshiftthedemandorsupplycurveforlabor.Therefore,(w/P)*andL*donotchange.,MacroeconomicsChapter11,43,InflationintheEquilibriumBusiness-CycleModel,InflationandtheRealEconomyRealGDP,Y,isdeterminedbytheproductionfunctionY=AF(K,L)WeconcludethatachangeindoesnotinfluencerealGDP,Y.,MacroeconomicsChapter11,44,InflationintheEquilibriumBusiness-CycleModel,InflationandtheRealEconomyTherealrentalprice,R/P,andthecapitalutilizationrate,determinetherealrateofreturnfromowningcapital,(R/P)(),andthereforetherealinterestrate,r,r=(R/P)().SinceR/Pandareunchanged,wefindthatachangeintheinflationrate,doesnotaffecttherealinterestrate,r.,MacroeconomicsChapter11,45,InflationintheEquilibriumBusiness-CycleModel,InflationandtheRealEconomyIfwecontinuetoignoreincomeeffectsfrominflation,weknowthatCdoesnotchange.SinceYisfixed,weconcludethatIdoesnotchange.,MacroeconomicsChapter11,46,InflationintheEquilibriumBusiness-CycleModel,Wehavefoundthatthetimepathsofmoneygrowthandinflationdonotaffectagroupofrealvariables.ThisgroupcomprisesrealGDP,Y;inputsoflaborandcapitalservices,LandK;consumptionandinvestment,CandI;therealwagerate,w/P;therealrentalprice,R/P;andtherealinterestrate,r.Theneutralityofmoneyapply,asanapproximation,totheentirepathofmoneygrowth.,MacroeconomicsChapter11,47,InflationintheEquilibriumBusiness-CycleModel,MoneyGrowth,Inflation,andtheNominalInterestRateAnalyzehowthetimepathofthenominalquantityofmoney,Mt,determinesthetimepathofthepricelevel,Pt,and,hence,theinflationrate,t.WealsoassumefornowthatYtandrtareconstantovertime.,MacroeconomicsChapter11,48,InflationintheEquilibriumBusiness-CycleModel,MoneyGrowth,Inflation,andtheNominalInterestRateMt=Mt+1Mtt=Mt/MtMt+1=(1+t)Mtt=Pt/Ptt=(Pt+1Pt)/PtPt+1=(1+t)Pt,MacroeconomicsChapter11,49,InflationintheEquilibriumBusiness-CycleModel,MoneyGrowth,Inflation,andtheNominalInterestRateShowthatWhenMtgrowssteadilyattherate,thepricelevel,Pt,willalsogrowsteadilyattherate.=,MacroeconomicsChapter11,50,InflationintheEquilibriumBusiness-CycleModel,MoneyGrowth,Inflation,andtheNominalInterestRateTherealquantityofmoneydemanded,L(Y,i),doesnotvaryovertime.realGDP,Y,isfixed.i=r+i=r+Sinceweassumedthatrandarefixed,iisunchanging.SinceYandiarefixed,wehaveverifiedthattherealquantityofmoneydemanded,L(Y,i),isunchanging.,MacroeconomicsChapter11,51,InflationintheEquilibriumBusiness-CycleModel,MoneyGrowth,Inflation,andtheNominalInterestRateThelevelofrealmoneydemanded,L(Y,i),equalstheunchanginglevelofrealmoneybalances,Mt/Pt.L(Y,i)andMt/Ptarebothfixedovertime.Therefore,ifthelevelsofthetwovariablesareequalinthecurrentyear,year1,theywillremainequalineveryfutureyear.,MacroeconomicsChapter11,52,InflationintheEquilibriumBusiness-CycleModel,MoneyGrowth,Inflation,andtheNominalInterestRateDeterminationofpricelevel:P1=M1/L(Y,i)t,istheconstant=.,MacroeconomicsChapter11,53,InflationintheEquilibriumBusiness-CycleModel,MoneyGrowth,Inflation,andtheNominalInterestRateTheinflationrate,equalstheunchanginggrowthrateofmoney,.Realmoneybalances,Mt/Pt,arefixedovertime.Thenominalinterestrate,i,equalsr+,whereristheunchangingrealinterestrate.,MacroeconomicsChapter11,54,InflationintheEquilibriumBusiness-CycleModel,MoneyGrowth,Inflation,andtheNominalInterestRateTherealquantityofmoneydemanded,L(Y,i),isfixedovertime,whereYistheunchangingrealGDP.P1=M1/L(Y,i),MacroeconomicsChapter11,55,InflationintheEquilibriumBusiness-CycleModel,ATrendintheRealDemandforMoneyAssumethatL(Y,i)growssteadilyattheconstantrate.Thisgrowthmightreflectlong-termgrowthofrealGDP,MacroeconomicsChapter11,56,InflationintheEquilibriumBusiness-CycleModel,ATrendintheRealDemandforMoneyRealmoneybalances,Mt/Pt,increasebecauseofgrowthinthenumerator,Mt,attherate,butdecreasebecauseofgrowthinthedenominator,Pt,attherate.growthrateofMt/Pt=,MacroeconomicsChapter11,57,InflationintheEquilibriumBusiness-CycleModel,ATrendintheRealDemandforMoneyIfL(Y,i)growsatrate,Mt/Ptmustalsogrowatrate.=,Macroecon