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Intermediate Macroeconomics Unit 3: Money and Inflation

This unit explains how the money supply is created, why sustained money growth causes inflation in the long run, and how inflation affects interest rates and the economy.

Covers: Functions and measures of money, Money supply process and the money multiplier, Quantity theory of money, Fisher effect and real interest rates, Money demand and the nominal interest rate, Costs of inflation, Seigniorage and hyperinflation

Study guide

Money is the stock of assets readily used for transactions. It serves as a medium of exchange, a unit of account and a store of value. Modern money is fiat money, valuable because people accept it, not because it is backed by a commodity. The central bank controls the monetary base B (currency plus bank reserves), while the money supply M (currency plus deposits) also depends on banks and the public. If the public holds currency equal to cr times deposits and banks hold reserves equal to rr times deposits, the money multiplier is m = (cr + 1) ÷ (cr + rr), and M = m × B. The central bank changes the base through open-market operations and influences the multiplier through reserve rules and interest on reserves.

The quantity equation M × V = P × Y is an identity: money times velocity equals nominal GDP. The quantity theory adds the assumption that velocity is roughly constant. In growth rates, %ΔM + %ΔV = %ΔP + %ΔY, so with stable velocity, inflation equals money growth minus real output growth. Because output is set by factors and technology in the long run, faster money growth shows up one for one in inflation. This is the classical dichotomy: real variables are determined by real forces, and money is neutral, affecting only nominal variables such as prices and nominal wages.

The nominal interest rate i is the return in dollars; the real rate r is the return in goods. The Fisher equation links them: i = r + π. The ex ante real rate uses expected inflation, the ex post real rate uses actual inflation. Since r is determined in the loanable funds market, a permanent rise in expected inflation raises i one for one, which is the Fisher effect. Money demand depends on income and the nominal interest rate, (M/P)ᵈ = L(i, Y), because i is the opportunity cost of holding money. As a result, news about future money growth raises expected inflation and i today, lowers real money demand and pushes up today's price level.

Inflation has costs even when it is expected. Shoe-leather costs come from holding less cash, menu costs from changing posted prices, relative-price variability from staggered price changes, and tax distortions because tax codes treat nominal gains and nominal interest as income. Unexpected inflation adds a further cost: it arbitrarily redistributes wealth, helping borrowers and hurting lenders with fixed nominal contracts. Some economists point to benefits of mild inflation, such as allowing real wages to fall without nominal wage cuts.

Governments can pay for spending by printing money, earning seigniorage. Seigniorage acts like an inflation tax on everyone holding money. When governments rely heavily on it, usually because they cannot tax or borrow enough, money growth explodes and hyperinflation follows, with inflation above 50% a month. Hyperinflation creates a vicious circle: rising inflation lowers real money demand and real tax revenue, so even more money must be printed. Hyperinflations end with fiscal reform that eliminates the need for seigniorage, often together with a new, credible central bank.

Key ideas

• The money supply equals the money multiplier times the monetary base.
• With constant velocity, inflation equals money growth minus real output growth.
• Money is neutral in the long run: it affects prices, not real output or real interest rates.
• The Fisher equation is i = r + π, and higher expected inflation raises i one for one.
• Real money demand falls when the nominal interest rate rises.
• Expected inflation has shoe-leather, menu and tax costs; unexpected inflation also redistributes wealth.
• Hyperinflation is caused by printing money to finance government deficits.

Formulas and rules

Common mistakes

• Using 1/rr as the multiplier when the public also holds currency.
• Subtracting real growth from inflation instead of from money growth in the quantity theory.
• Thinking a permanent rise in inflation lowers the real interest rate in the long run.
• Claiming expected inflation redistributes wealth from lenders to borrowers; only unexpected inflation does.
• Treating the quantity equation identity as a theory without the constant-velocity assumption.

Before the test, make sure you can

• Calculate the money supply from the base, currency ratio and reserve ratio.
• Predict how open-market operations, reserve requirements and bank panics change the money supply.
• Use the quantity equation in growth rates to find inflation, money growth or velocity.
• Calculate ex ante and ex post real interest rates and explain the Fisher effect.
• Explain why money demand depends on the nominal interest rate and how expectations affect today's prices.
• Distinguish the costs of expected and unexpected inflation, including tax effects.
• Explain seigniorage and the cause and cure of hyperinflation.

Words to know

Fiat money

Money with no intrinsic value, accepted because of government decree and convention.

Monetary base

Currency in circulation plus bank reserves; directly controlled by the central bank.

Money multiplier

The ratio of the money supply to the monetary base, (cr + 1)/(cr + rr).

Reserve-deposit ratio

The share of deposits that banks hold as reserves.

Currency-deposit ratio

The amount of currency people hold relative to their bank deposits.

Open-market operations

Central bank purchases or sales of government bonds that change the monetary base.

Bank leverage

The ratio of a bank's assets to its capital; it magnifies gains and losses.

Velocity

Nominal GDP divided by the money supply: how often money turns over.

Quantity theory of money

With constant velocity, nominal GDP is proportional to money, so money growth drives inflation.

Classical dichotomy

The separation of real and nominal variables in the long-run classical model.

Monetary neutrality

Changes in the money supply do not affect real variables.

Fisher equation

i = r + π: the nominal rate equals the real rate plus inflation.

Ex post real interest rate

The nominal rate minus actual inflation.

Shoe-leather costs

Resources wasted when high inflation leads people to hold less money.

Menu costs

The costs of changing posted prices.

Seigniorage

Government revenue from creating money; an inflation tax on money holders.

Hyperinflation

Extremely high inflation, often defined as more than 50% per month.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.