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Role of Money:
(Prices, Inflation, Interest Rate - inter-links)
Connection between
Learning Objectives Money & Prices
• What is role of money? – Concept, definition and • Price = amount of money (M) required to
impacts
• How money supply affects the economy? buy a good. (P = rate at which money is
Measuring Quantity of Money – stock of assets used for exchanged for goods & services)
transaction
• What are the factors affect money market – • Inflation rate = the percentage increase
money supply and demand? – control of money in the average level of prices (P).
supply, monetary policy
• How quantity of money determines price level • Because prices (P) are defined in terms of
and inflation? – relation between money supply (M), money, we need to consider the nature of
prices (P), inflation (), interest rate (i) & income or
output (Y) or AD money, the supply of money, and how it is
• How inflation affects interest rate and the controlled.
economy as a whole?
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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
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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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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.
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• 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 Back to the quantity theory of money
• starts with quantity equation
• money demand: (M/P)d = kY • assumes V is constant & exogenous: V V
• quantity equation: M V = P Y
Then, quantity equation becomes:
• The connection between them: k = 1/V
• When people hold lots of money relative
to their incomes (k is large), or money M V P Y
changes hands infrequently (when V is small).
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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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
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)
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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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Summary Summary
Money Nominal interest rate
– def: the stock of assets used for transactions – equals real interest rate + inflation rate
– functions: medium of exchange, store of value, – the opp. cost of holding money
unit of account
– Fisher effect: Nominal interest rate moves
– types: commodity money (has intrinsic value), one-for-one w/ expected inflation.
fiat money (no intrinsic value)
Money demand
– money supply controlled by central bank
– depends only on income in the Quantity Theory
Quantity theory of money assumes velocity is stable, – also depends on the nominal interest rate
concludes that the money growth rate determines the – if so, then changes in expected inflation affect the
inflation rate. current price level.