Why should a rise in the price level (but not in expected inflation) cause interest rates to rise when the nominal money supply is fixed? (Answer: When the price level rises, the quantity of money in real terms falls (holding the nominal supply of money constant); to restore their holdings of money in real terms to their former level, people. Ney honey (Click to select) rises -ney hd for is unaffected by falls e return on money (Click to select), regardless of the le The expected real yields on money and on eBook What if expected inflation rose by 3 percent Ask (Click to select) pney and on reduces assets rose ir increases CATEG volments relative the portfolio demand for mo (Click. Inflation occurs when there is a general increase in the price of goods and services, which leads to a fall in the purchasing value of money. Inflation can benefit both borrowers and lenders. Answer When the price level rises, the quantity of money in real terms falls (holding the nominal supply of money constant); to restore their holdings of money in real terms to their former level, people will want to hold a greater nominal quantity of money. Thus the money demand curve Md shifts to the right, and the interest rate rises.

When Expected Inflation Falls Real Money Demand Increases As A
When Expected Inflation Falls Real Money Demand Increases Due
When Expected Inflation Falls Real Money Demand Increases Due

Last updated: February 2, 2000

Note: These notes are preliminary and incomplete and they are not guaranteed to be free of errors. Please let me know if you find typos or other errors.

The Asset Market

Up to now we have covered (1) the labor market and the production function, where real wages, employment and potential output is determined, and (2) the market for goods and services, where the real interest rate and investment and saving are determined. Now we consider the market for financial assets (money and 'bonds') by focusing on the demand and supply of money in the economy. This will give us insights into other forces on interest rates - particularly those created by the Fed - and also on the ultimate determinants of inflation.

What is Money?

Medium of exchange - barter is inefficient.
Unit of account - money is the basic unit for measuring economic value.
Store of value - money can be used to hold wealth.
Low return (interest rate) - money pays no interest
Low risk - money is a 'safe' asset in low inflation times
High liquidity - money is the most liquid asset (money is accepted immediately for almost all transactions)

Definitions of monetary aggregates

Symbol	Assets Included	Billions of dollars (1996)
C	Currency	$358.9
M1	Currency, demand deposits, traveler's checks, checkable deposits.	$1,095.3
M2	Currency, M1, overnight repos, eurodollars, money market deposit accounts, money market mutual funds, saving and small time deposits.	$3,761.1

In this class, when we talk about the nominal money supply we will generally be referring to the monetary aggregate M1. Hereafter, the symbol 'M' will denote M1.

The supply of money

The Federal Reserve Bank (Fed)

The Federal Reserve Bank (Fed) ultimately controls the supply of money in the economy. (How it does this and how the banking system works is detailed in the lectures on the Fed and Monetary Policy.) The Fed is the central bank for the U.S. and is a quasi-private entity (technically owned by private banks) created by the Federal Reserve Act in 1913. There are twelve regional Federal Reserve Banks across the country and the leadership of the system is conducted by the Board of Governors of the Federal Reserve System (Federal Reserve Board ). The Board consists of seven governors, appointed by the President to staggered fourteen-year terms. The President appoints one Board member as chairman - currently Allen Greenspan - for a term of four years. It is important to keep in mind that the Fed operates independently of the federal government. Congress and the President do not have direct control over the operations of the Fed.

How the Fed Controls the Money Supply

The Fed primarily controls the supply of money (M1) in the economy through what are called open market operations. These are the purchase and sale of government bonds by the Fed. The Fed operates the printing presses for the creation of currency. The Fed also owns a substantial amount of U.S. government bonds. When the Fed wants to increase the supply of money it performs an open market purchase of government bonds. That is, the Fed buys (by printing money) outstanding government bonds from the public or new government bonds from the Treasury (to finance the current deficit). This operations injects new cash into the economy. Conversely, when the Fed wants to decease the amount of money in the economy it performs an open market sale of government bonds. Here, the Fed sells some of its holdings of government bonds to the public in exchange for cash. This operation takes cash out of the economy.

Portfolio Allocation and the Demand for Assets

Portfolio theory tells us how individuals allocate their wealth among a number of financial assets (e.g. stocks, bonds, real estate, money). In general an individual's demand for assets is based on comparing the benefits of costs of holding different kinds of assets. These costs and benefits are functions of the following assets characteristics:

Expected return - expected gain (or loss) from holding an asset over a particular investment horizon
Risk - the degree of uncertainty in an asset's return
Liquidity - the ease and quickness that an asset can be traded

An individual's demand for money is then based on the costs and benefits of holding money. As an asset, money has a very low expected return (it pays no interest), is very safe (the gov't guarantees its nominal value) and is the most liquid asset.

Simplifying assumptions

Since the general asset allocation problem involves many different kinds of assets with different risk and return characteristics we simplify this decision by assuming that there are only two kinds of financial assets in the economy.

Money assets - low return, high liquidity and low risk. i_m = nominal interest rate on money assets (very low).
Non-money assets (bonds) - higher return than on money assets and less liquidity. We assume that the risk associated with investing in bonds is not too high (think of government bonds as the generic non-money asset). Let i denote the nominal interest rate on non-money assets. Note that, by assumption, i > i_m. Also, recall that i = r +p^e, where r denotes the real return on non-money assets and p^e denotes expected inflation.

Behavorial Model for Money Demand

Our model for the demand for nominal money balances takes the following form

M^d = P·L^d(Y, i)

where

M^d = demand for nominal money balances (demand for M1)
L^d= demand for liquidity function
P = aggregate price level (CPI or GDP deflator)
Y = real income

When Expected Inflation Falls Real Money Demand Increases