Macroeconomics Chapter 11,1,Inflation, Money Growth, and Interest Rates,C h a p t e r 1 1,Macroeconomics Chapter 11,2,Cross-Country Data on Inflation and Money Growth,Key equation: Ms = P L(Y, i) Two possible reasons of inflation: Decrease of real demand for money Increase of money supply,Macroeconomics Chapter 11,3,Cross-Country Data on Inflation and Money Growth,Inflation rates and money growth rates for 82 countries from 1960 to 2000. We measure the price level, P, by the consumer price index (CPI). We use the CPI, rather than the GDP deflator, because of data availability.,Macroeconomics Chapter 11,4,Macroeconomics Chapter 11,5,Macroeconomics Chapter 11,6,Macroeconomics Chapter 11,7,Cross-Country Data on Inflation and Money Growth,Highlights The inflation rate was greater than 0 for all countries from 1960 to 2000 The growth rate of nominal currency was greater than 0 for all countries from 1960 to 2000. There is a broad cross-sectional range for the inflation rates and the growth rates of money.,Macroeconomics Chapter 11,8,Cross-Country Data on Inflation and Money Growth,Highlights The median inflation rate from 1960 to 2000 was 8.3% per year, with 30 countries exceeding 10%. For the growth rate of nominal currency, the median was 11.6% per year, with 50 above 10%,Macroeconomics Chapter 11,9,Cross-Country Data on Inflation and Money Growth,Highlights In most countries, the growth rate of nominal currency, M, exceeded the growth rate of prices. For a country that has a high inflation rate in one period to have a high inflation rate in another period. Strong positive association between the inflation rate and the growth rate of nominal currency.,Macroeconomics Chapter 11,10,Cross-Country Data on Inflation and Money Growth,Macroeconomics Chapter 11,11,Cross-Country Data on Inflation and Money Growth,One lesson from the cross-country data is that, to understand inflation, we have to include money growth as a central part of the analysis. Milton Friedmans famous dictum: “Inflation is always and everywhere a monetary phenomenon.”,Macroeconomics Chapter 11,12,Inflation and Interest Rates,Actual and Expected Inflation Let be the inflation rate. The inflation rate from year 1 to year 2, 1, is the ratio of the change in the price level to the initial price level. 1 = ( P2 P1)/ P1 1 = P1/ P1,Macroeconomics Chapter 11,13,Inflation and Interest Rates,Actual and Expected Inflation 1 = ( P2 P1)/ P1 1 = P1/ P1 1 P1 = P2 P1 P2 = ( 1 +1) P1,Macroeconomics Chapter 11,14,Inflation and Interest Rates,Actual and Expected Inflation Since the future is unknown, households have to form forecasts or expectations of inflation. Denote by e1 the expectation of the inflation rate 1. The actual inflation rate, 1, will usually deviate from its expectation, e1, and the forecast erroror unexpected inflationwill be nonzero.,Macroeconomics Chapter 11,15,Inflation and Interest Rates,Actual and Expected Inflation Households try to keep the errors as small as possible. Therefore, they use available information on past inflation and other variables to avoid systematic mistakes. Expectations formed this way are called rational expectations.,Macroeconomics Chapter 11,16,Inflation and Interest Rates,Real and Nominal Interest Rates The dollar value of assets held as bonds rises over the year by the factor 1 + i1. The interest rate i1 is the dollar or nominal interest rate because i1 determines the change over time in the nominal value of assets held as bonds.,Macroeconomics Chapter 11,17,Inflation and Interest Rates,Macroeconomics Chapter 11,18,Inflation and Interest Rates,Real and Nominal Interest Rates The Real interest rate to be the rate at which the real value of assets held as bonds changes over time. dollar assets in year2 = ( dollar assets in year1)(1+ i1) P2 = P1 ( 1 + 1),Macroeconomics Chapter 11,19,Inflation and Interest Rates,Real and Nominal Interest Rates (dollar assets in year2/P2 )= (dollar assets in year1/P1) (1+i1)/(1+1) real assets in year2 = (real assets in year1) (1+i1)/(1+1),Macroeconomics Chapter 11,20,Inflation and Interest Rates,Real and Nominal Interest Rates Since the real interest rate, denoted by r1, is the rate at which assets held as bonds change in real value: (1+r1) = (1+i1)/(1+1),Macroeconomics Chapter 11,21,Inflation and Interest Rates,Real and Nominal Interest Rates r1 = i1 1 r11 the cross term, r1 1, which tends to be small; real interest rate= nominal interest rate inflation rate r1 = i1 1,Macroeconomics Chapter 11,22,Inflation and Interest Rates,Fisher Equation i = r + Fisher Effect i ,Macroeconomics Chapter 11,23,Inflation and Interest Rates,The Real Interest Rate and Intertemporal Substitution When the inflation rate, , is not zero, it is the real interest rate, r, rather than the nominal rate, i, that matters for intertemporal substitution.,Macroeconomics Chapter 11,24,Inflation and Interest Rates,Actual and Exp