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Chapter 11: Inflation, Money Growth, and Interest
Rates
Chapter Summary:
The chapter attempts to explain the relationship between inflation, money
growth and interest rates using the tools of equilibrium business cycle theory and the
theory of money supply and demand developed in previous chapters. It begins by
examining the international data on inflation rates and establishes the link between
nominal monetary growth and inflation rates. Then the chapter describes the impact
The difference between the growth rate of the money supply and money
demand determines the rate of inflation. Changes in the growth rate of money are
shown to cause rapid changes in the price level; the mere anticipation of the change
can cause the price level to “jump”. The section shows how this “jump” is related to
the theory of money demand.
Chapter Outline:
I. Cross Country Data on Inflation and Money Growth
II. Inflation and Interest Rates
A. Actual and Expected Inflation
B. Real and Nominal Interest Rates
ii. U.S expected inflation and inflation and interest since WW II
iii. Indexed bonds, real interest rates, and expected inflation rates
III. Inflation in the Equilibrium Business-Cycle Model
A. Intertemporal-Substitution Effects
B. Bonds and Capital
Teaching Tips:
1. This chapter covers a lot of ground, so it may require more class time than other
2. The “neutrality” of money is one of the key results of the equilibrium model.
Remind students of this fact when examining the international data on monetary
3. One of the difficult concepts for students to use correctly is the idea of real money
balances, but understanding how real money balances evolve is important to the
Answers to review questions, pg. 287
2. The real interest rate is the nominal interest rate – inflation. Positive rates of
inflation change the purchasing power of money over time, reducing the real value
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3. The actual rate can only be determined after the fact, when actual inflation rates
can be measured. Before the fact, inflation rates can only be predicted.
4. The Livingston survey is survey of 50 economists concerning inflation forecasts.
The forecast uses “experts” as opposed to households. The extent to which
5. The nominal rate cannot determine the opportunity cost of consuming goods
today rather than in the future. Only the real interest rate can do that, because it
Answers to Problems for Discussion, pg. 287-88
6. a. A high rate of growth in real GDP weakens the link between and .. If the
real economy grows at about the same rate as the money supply, there is no reason to
expect positive rates of inflation. Given the assumptions on money demand made in
this problem, money demand will grow at the same rate as the money supply.
7. a. The results are shown below (results were obtained using MS excel):
Coefficients
Standard Error
t Stat
Intercept
0.037889295
0.006393448
5.926269
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b. The results are shown below:
Coefficients
Standard
Error
t Stat
Intercept
-0.00879
0.009138
-0.96185
1.006961
c. The results are shown below:
Standard Error
t Stat
Intercept
0.006156435
6.027166
0.120475626
1.584838
0.152706513
8. a. the price level increases proportionately, but nominal interest rates do not
change.
9. a. The high demand for money would create a disequilibrium at the current price
level; prices would tend to fall during periods of increased money demand and rise
after the first of the year. Short term inflation and nominal rates would follow the
same pattern.
10. If there is a temporary increase in money demand then people will want to
increase their money balances. As we saw in chapter 10, this would cause a one time
reduction in the price level. This does not affect nominal interest rates however,
because the one time change in the price level has no effect on the growth rate of
11.9. One way for the central bank to gain credibility is to announce a target for
inflation. Countries that do this credibly have an essentially passive monetary policy
that accommodates changes in money demand without causing inflation. The
nominal interest rate changes only in response to changes in the real interest rate.
11. Government revenue from printing money increases with , but decreases with
respect to real balances, (see equation 11.22 on page 284) Higher will lead to higher
12. a. Issuers are likely to “call” the bond when the nominal rate on the bond is
higher than the nominal rate on the market. A unexpected reduction in the nominal
rate would trigger the increase in prepayments.
13. Rational expectations allows us to make use of all available information to
identify the expected rate during the period in question. However, it is also difficult
14. a. The nominal rate is 5%. The expected rate is 5%-the expected rate of inflation.
The actual rate is 5%-the actual rate of inflation. Obviously the real rate depends on
information which cannot be know until after the purchase.
15. The counterfeiting was sufficient to create some inflation and higher nominal
interest rates, which would ultimately lead to lower real money balances. By