Lecture Nine
Monetary Policy; Real and Nominal Interest Rates
(Economics 100b; Spring 1996)
Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net
February 7, 1996
How to Link the Quantity Theory to F(K, L)?
Controlling the Quantity of Money
Real and Nominal Interest Rates
The Fisher Effect; Ex-Ante and Ex-Post Real Interest Rates
Economic and Social Costs of Inflation
How to Link the Quantity Theory to F(K, L)?
How do you link up this "quantity theory" that claims to tell you
what P times Y is, with our model of last week that told us that Y =
F(K, L)?
"Very carefully"
Right answer comes later on in the course...
This week we settle for a not-very-wrong answer. Suppose (never mind
how) all of a sudden people find themselves with a lot more
currency--large bills airdropped from helicopters, say. In the
standard circular flow diagram people goose up their spending...
But there are no more commodities for them to buy...
Hence prices rise a bunch...
And as prices rise a bunch, firms find themselves making profits, bid
for workers, nominal wages rise, and eventually you get back
to the same real equilibrium as far as commodities and real
incomes are concerned, but the price level is higher. We get
real variables from chapter 3's model, and nominal
variables from the quantity equation.
Inflation = M growth + V growth - Y growth
How good is the quantity-theoretic approach to inflation?
Very good across countries (especially if some of the countries have
truly outlandish rates of inflation)...
Not very good year-to-year...
OK--but not great--decade-by-decade
When has the US had inflation? Seignorage; direct seignorage--and
implicit defaults on the government's debt...
Controlling the Quantity of Money
The quantity of money is the result of myriads of private decisions.
How can the Federal Reserve--or anyone else--"control" it?
- Goodhart's Law
- Open market operations
- Reserve requirements
- Making money more expensive--even without binding reserve
requirements
- Question: does this have much effect on "spending"?
- Money as indicator as opposed to money as control
variable
Real and Nominal Interest Rates
8% nominal interest rate; suppose inflation is 5%; how much
"richer" are you after a year?
- If you care about the number of pieces of paper with pictures
of George Washington on them, 8%
- If you care about your ability to buy commodities, 3%
The Fisher Effect; Ex-Ante and Ex-Post Real Interest Rates
Irving Fisher; the "Fisher effect": i = r + π
The real interest rate--r-- is determined by equilibrium in the
loanable funds market:
Sp = DEF + I(r)
The nominal interest rate is the sum of the real interest rate and
expected inflation.
One-for-one shifts in nominal interest rates and expected
inflation
T-bill rate and GDP deflator inflation rate:
Economic and Social Costs of Inflation
- "Common fallacy": inflation in its pure form does not affect
real incomes (but people think it does, and that is why they do
not like it...
- Cost of holding money--lower real money balances, so-called
shoeleather costs of inflation; menu costs.
- Sand in the gears of the price mechanism. Rigid nominal prices
aren't quite right. No one really knows what true relative prices
are; money as a yardstack...
- Inflation, tax rules, and capital formation...
- Unexpected inflation--bad news for individuals with fixed
nominal credits; good news for individuals with fixed nominal
debts...; indexation
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