Money, Interest, and Inflation

12 Money, Interest, and Inflation CHECKPOINTS

Checkpoint 12.1 Checkpoint 12.2 Checkpoint 12.3 Problem 1 Problem 1 Problem 1 Problem 2 Problem 2 Problem 2 Problem 3 Problem 3 Problem 4 Problem 4 Problem 5

Practice Problem 1 The figure shows the demand for money curve. If the quantity of money is $4 trillion, what is the supply of money and the nominal interest rate? CHECKPOINT 12.1

Solution The supply of money is the curve MS. The interest rate is 4 percent a year, at the intersection of MD1 and MS. CHECKPOINT 12.1

Practice Problem 2 The figure shows the demand for money curve. If the quantity of money is $4 trillion and real GDP increases, how will the interest rate change? Explain the process that brings about the change in the interest rate. CHECKPOINT 12.1

Solution An increase in real GDP increases the demand for money. The demand for money curve shifts rightward from MD1 to MD2. At an interest rate of 4 percent a year, people want to hold more money, so they sell bonds. As the supply of bonds increases, the price of a bond falls and the interest rate rises. CHECKPOINT 12.1

Practice Problem 3 If the Fed decreases the quantity of money from $4.0 trillion to $3.9 trillion, how will bond prices change? Why? CHECKPOINT 12.1

Solution At an interest rate of 4 percent a year, people would like to hold $4.0 trillion. With only $3.9 trillion of money available, people are holding only $3.9 trillion of money, so they sell some bonds. As the supply of bonds increases, the price of a bond falls, and the interest rate rises. CHECKPOINT 12.1

Practice Problem 4 Suppose that banks introduce a user fee on every credit card purchase and increase the interest rate on outstanding credit card balances. How will the demand for money and the nominal interest rate change? CHECKPOINT 12.1

Solution With a fee on each transaction, people will use credit cards less frequently. With a higher interest rate on outstanding balances, the opportunity cost of holding money increases. The demand for money will increase and with no change in the supply of money, the nominal interest rate will rise. CHECKPOINT 12.1

Practice Problem 5 What to do with $50,000 now A good strategy: Put about two-thirds of the money into a fund that invests mostly in bonds of developed nations and put the rest into a riskier emerging market bond fund. Source: CNNMoney.com What is the opportunity cost of holding money? If lots of people followed this advice and put their money into bonds, explain what will happen to the demand for money, the price of bonds, and the interest rate on bonds. CHECKPOINT 12.1

Solution The opportunity cost of cash is the highest interest rate forgone by not holding bonds of a similar risk. As lots of people decide to buy bonds, the demand for money decreases. The demand for bonds increases and with no change in the supply of bonds, the price of a bond rises and the interest rate on bonds falls. CHECKPOINT 12.1

Practice Problem 1 Use the data in the table to calculate the real interest rate. If the real interest rate remains unchanged when the inflation rate increases to 4 percent a year, explain how the nominal interest rate changes in the long run. CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

Solution The real interest rate equals the nominal interest rate minus the inflation rate. Real interest rate = (6  2) percent a year = 4 percent a year. The nominal interest rate rises from 6 percent a year to 8 percent a year. CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

Practice Problem 2 Use the data in the table to calculate the quantity of money in Canada. CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

Solution Velocity of circulation (V) equals Nominal GDP (P x Y) divided by Quantity of Money (M). Rewrite this equation as: M = (P x Y) ÷ V. (P x Y) = $866 billion × 1.1 = $975 billion, so M = $975 billion ÷ 10 = $97.5 billion. CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10. • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

Practice Problem 3 Use the data in the table. If the quantity of money in Canada grows at 10 percent a year and potential GDP grows at 3 percent a year, what is the inflation rate in the long run? CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

Solution With velocity constant, velocity growth is zero. So in the long run, Inflation rate equals Money growth rate minus Real GDP growth rate. Inflation rate = 10 percent a year minus 3 percent a year, which is 7 percent a year. CHECKPOINT 12.2 • In 1999, the Canadian economy at full employment. • Real GDP was $886 billion. • The nominal interest rate was around 6 percent per year. • The inflation rate was 2 percent a year. • The price level was 1.1. • The velocity of circulation was constant at 10.

Practice Problem 4 No rush to boost interest rates Some economists worry that the Fed’s policy of generating so much liquidity during 2008 will eventually spark inflation as the economy improves and banks increase their lending. Source: USA Today, October 8, 2009 Explain why some economists are worried about inflation taking hold. CHECKPOINT 12.2

Solution In the short run, an increase in liquidity is an increase in the quantity of money. With a given demand for money, an increase in the quantity of money lowers the interest rate in the short run. With no change in the interest rate, as the economy recovers from the recession of 2008–2009 and banks increase their lending, the quantity of money demanded will increase and there will be pressure on the interest rate to rise. CHECKPOINT 12.2

Some economists worry that to keep the interest rate constant in an attempt not to hinder the recovery, the Fed will increase the quantity of money. In the long run, as the quantity of money increases the value of money falls. A falling value of money is a rising price level—inflation. CHECKPOINT 12.2

Practice Problem 1 Ben has $1,000 in his savings account and the bank pays an interest rate of 5 percent a year. The inflation rate is 3 percent a year. The government taxes the interest that Ben earns on his deposit at 20 percent. Calculate the after-tax nominal interest rate and the after-tax real interest rate that Ben earns. CHECKPOINT 12.3

Solution Ben’s interest income equals 5 percent of $1,000, which is $50. The government takes $10 of his $50 in tax, so the interest income he earns after tax is $40. The nominal after-tax interest rate is ($40 ÷ $1,000) × 100, which equals 4 percent a year. CHECKPOINT 12.3

The after-tax real interest rate equals the after-tax nominal interest rate minus the inflation rate. The after-tax nominal interest rate is 4 percent a year. So the after-tax real interest rate equals 4 percent a year minus the inflation rate of 3 percent a year, which is 1 percent a year. CHECKPOINT 12.3

Practice Problem 2 Inflation-adjusted savings bonds hit 0% rate for first time Inflation-adjusted savings bonds purchased from May through October 2009 will earn 0% for the first six months. The fixed interest rate on these bonds is 0.1% and over the previous 6 months, inflation fell at an annual rate of 5.56%. The minimum interest rate on savings bonds is set at 0%. Source: USA Today, May 5, 2009 Are these savings bonds a better deal than cash under the mattress? CHECKPOINT 12.3

Solution At 0 percent interest rate, these bonds are just as good a deal as cash under the mattress. But if inflation starts to rise as the economy recovers from recession, the nominal interest rate will exceed 0.1 percent. The real interest rate will be certain and equal 0.1 percent a year—a better deal than cash. CHECKPOINT 12.3

Money, Interest, and Inflation