Chapter 25 - Money, Price Level and Inflation
Money is any commodity or token that is generally acceptable as a means of payment.
A means of payment is a method of settling a debt.
Money has three other functions:
- Medium of Exchange: is an object that is generally accepted in exchange for goods and services.
In the absence of money, people would need to exchange goods and services directly, which is
called barter. Barter requires a double coincidence of wants, which is rare, so barter is costly.
- Unit of Account: is an agreed measure for stating the prices of goods and services.
- Store of Value: money can be held for a time and later exchanged for goods and services.
Money in the United States Today
Money in the United States consists of:
- Currency is the notes and coins held by individuals and businesses.
- Deposits are money because the owners can use the deposit to make payments.
Official Measures of Money
The two main official measures of money in the United States are M1 and M2.
- M1 consists of currency and traveler’s checks and checking deposits owned by individuals and
businesses.
- M2 consists of M1 plus time deposits, saving deposits, money market mutual funds, and other
deposits.
Are M1 and M2 Really Money?
All the items in M1 are means of payment, so they are money.
Some saving deposits in M2 are not means of payments—they are called liquid assets. Liquidity is the
property of being instantly convertible into a means of payment with little loss of value.
Deposits are Money but Checks Are Not
In defining money, we include, along with currency, deposits at banks and other depository institutions.
A check is an instruction to a bank to transfer money. A check is not money, but the deposit on which it
is written is money.
Credit Cards Are Not Money?
A credit card enables the holder to obtain a loan, but it must be repaid with money. Credit cards are not
money.
How much money do people want to hold?
The Influences on Money Holding
The quantity of money that people plan to hold depends on four main factors:
- The Price Level: A rise in the price level increases the quantity of nominal money but doesn’t
change the quantity of real money that people plan to hold. Nominal money is the amount of
money measured in dollars. Real money equals nominal money ÷ price level. The quantity of
nominal money demanded is proportional to the price level—a 10 percent rise in the price level
increases the quantity of nominal money demanded by 10 percent.
- The Nominal Interest Rate: The nominal interest rate is the opportunity cost of holding wealth
in the form of money rather than an interest-bearing asset. A rise in the nominal interest rate on
other assets decreases the quantity of real money that people plan to hold.
- Real GDP: An increase in real GDP increases the volume of expenditure, which increases the
quantity of real money that people plan to hold.
- Financial Innovation: Financial innovation that lowers the cost of switching between money and
interest-bearing assets decreases the quantity of real money that people plan to hold.
The Demand for Money: is the relationship between the quantity of real money demanded and the
nominal interest rate when all other influences on the amount of money that people wish to hold
remain the same.
Figure 25.4 illustrates the demand for money curve.
A rise in the interest rate brings a decrease in the quantity of real money demanded. Whereas, a fall in
the interest rate brings an increase in the quantity of real money demanded.
Shifts in the Demand for Money Curve
Figure 25.5 shows that a decrease in real GDP or a financial
innovation decreases the demand for money and shifts the
demand curve leftward. An increase in real GDP increases
the demand for money and shifts the demand curve
rightward.
Money Market Equilibrium
Money market equilibrium occurs when the quantity of money demanded equals the quantity of money
supplied. Adjustments that occur to bring about money market equilibrium are fundamentally different
in the short run and the long run.
Short-Run Equilibrium
Figure 25.6 shows the demand for money.
Suppose that the Fed uses open market operations to make the quantity of money $3 billion. The
equilibrium interest rate is 5 percent a year. If the interest rate is 4 percent a year, the quantity of
money that people plan to hold exceeds the quantity supplied.
People try to get more money by selling bonds. This action raises the interest rate.
The Short-Run Effect of a Change in the Quantity of Money
Initially, the interest rate is 5 percent a year. If the Fed increases the quantity of money, people will be
holding more money than the quantity demanded.
They buy bonds. The increased demand for bonds raises the bond price and lowers the interest rate.
Initially, the interest rate is 5 percent a year. If the Fed decreases the quantity of money, people will be
holding less money than the quantity demanded. They sell bonds. The increased supply of bonds lowers
the bond price and raises the interest rate.
Long-Run Equilibrium
In the long run, the loanable funds market determines the real interest rate. The nominal interest rate
equals the equilibrium real interest rate plus the expected inflation rate. In the long run, real GDP equals
potential GDP, so the only variable left to adjust in the long run is the price level.
The price level adjusts to make the quantity of real money supplied equal to the quantity demanded.
If in long-run equilibrium, the Fed increases the quantity of money, the price level changes to move the
money market to a new long-run equilibrium. In the long run, nothing real has changed. Real GDP,
employment, quantity of real money, and the real interest rate are unchanged. In the long run, the price
level rises by the same percentage as the increase in the quantity of money.
The Transition from the Short Run to the Long Run
1. Start in full-employment equilibrium:
2. If the Fed increases the quantity of money by 10 percent, the nominal interest rate falls.
3. As people buy bonds, the real interest rate falls.
4. As the real interest rate falls, consumption expenditure and investment increase. Aggregate
demand increases.
5. With the economy at full employment, the price level rises.
6. As the price level rises, the quantity of real money decreases.
7. The nominal interest rate and the real interest rate rise.
8. As the real interest rate rises, expenditure plans are cut back and eventually the original full-
employment equilibrium is restored.
9. In the new long-run equilibrium, the price level has risen by 10 percent but nothing real has
changed.
The quantity theory of money is the proposition that, in the long run, an increase in the quantity of
money brings an equal percentage increase in the price level. The quantity theory of money is based on
the velocity of circulation and the equation of exchange.
The velocity of circulation is the average number of times in a year a dollar is used to purchase goods
and services in GDP.
Calling the velocity of circulation V, price level P, real GDP Y, and the quantity of money M: V = PY ÷ M.
The equation of exchange states that: MV = PY. The equation of exchange becomes the quantity theory
of money if M does not influence V or Y. So in the long run, the change in P is proportional to the change
in M.
Expressing the equation of exchange in growth rates:
Money growth rate + Rate of velocity change = Inflation rate +Real GDP growth
Rearranging:
Inflation rate = Money growth rate + Rate of velocity change Real GDP growth
In the long run, velocity does not change, so:
Inflation rate = Money growth rate Real GDP growth
Chapter 25: Review Questions
1. In June 2013, currency held by individuals and businesses was $1,124 billion; traveler’s checks
were $4 billion; checkable deposits owned by individuals and businesses were $1,042 billion;
savings deposits were $6,884 billion; time deposits were $583 billion; and money market funds
and other deposits were $647 billion. Calculate M1 and M2 in June 2013.
2. Sara withdraws $1,000 from her savings account at the Lucky S&L, keeps $50 in cash, and
deposits the balance in her checking account at the Bank of Illinois. What is the immediate
change in M1 and M2?
3. In year 1, the economy is at full employment and real GDP is $400 million, the GDP deflator is
200 (a price level is 2), and the velocity of circulation is 20. In year 2, the quantity of money
increases by 20 percent. If the quantity theory of money holds, calculate the quantity of money,
the GDP deflator, real GDP, and the velocity of circulation in year 2.
4. Explain the change in the nominal interest rate in the short run if
a. Real GDP increases.
b. The money supply increases.
c. The price level rises.
5. Figure 8.3 shows the demand for money curve. If the Fed decreases the quantity of real money
supplied from $4 trillion to $3.9 trillion, explain how the price of a bond will change.
6. Calculate the values of X and Z.
1869 1879
Quantity of money $1.3 billion $1.7 billion
Real GDP (1929 dollars) $7.4 billion Z
Price level (1929 = 100) X 54
Velocity of circulation 4.50 4.61
