EC4004 Lecture 10Inflation, Money Growth,

Interest Rates

Stephen Kinsella | www.stephenkinsella.net

Last Time:Data

Inflation & Interest

Inflation in the Equilibrium Business-

Cycle Model

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Inflation in the Equilibrium Business-Cycle Model

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Inflation in the Equilibrium Business-Cycle Model

Intertemporal-Substitution Effects

The expected real interest rate, ret , has

intertemporal-substitution effects on consumption and labor supply.

Therefore, for given it, a change in πt will have these intertemporal-substitution effects.

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Inflation in the Equilibrium Business-Cycle Model

Bonds and Capital

@ ∆πt =0,

i = (R/P)·κ − δ(κ)

rate of return on bonds =

rate of return from owning capital

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Inflation in the Equilibrium Business-Cycle Model

Replace the nominal interest rate on bonds, i, by the real rate, r,

r = ( R/ P) · κ − δ(κ)

real rate of return on bonds =

real rate of return from owning capital.

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Inflation in the Equilibrium Business-Cycle Model

Interest Rates and the Demand for Money

It is the real interest rate, r, that has intertemporal-substitution effects on consumption and labor supply. However, it is the nominal interest, i, that influences the real demand for money, Md/P.

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Inflation in the Equilibrium Business-Cycle Model

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Inflation in the Equilibrium Business-Cycle Model

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Money Growth, Inflation, and the Nominal Interest Rate

∆Mt =Mt+1−Mt

µt = ∆Mt/Mt

Mt+1 = (1+µt)·Mt

πt = ∆ Pt/ Pt

πt = (Pt+1−Pt)/Pt

Pt+1 = (1+πt)·Pt

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Inflation in the Equilibrium Business-Cycle Model

The level of real money demanded, L(Y, i), equals the unchanging level of real money balances, Mt/Pt .

Determination of price level:

P1 = M1 / L( Y, i)

πt, is the constant π = µ.

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Inflation in the Equilibrium Business-Cycle Model

Government Revenue from Printing Money

Nominal revenue from printing money

= Mt+1−Mt = ∆Mt

Real revenue from printing money

= ∆Mt/ Pt+1

Real money growth rate

µt = ∆ Mt/ Mt

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Inflation in the Equilibrium Business-Cycle Model

Government Revenue from Printing Money

Real revenue from printing money

= µt·(Mt/Pt+1)

Real revenue from printing money

≈ µt·( Mt/ P)

= (money growth rate)·(level of real money

balances)

Next Time

Recap.

Read Barro chapters 1-12, come with questions.