© K. A. Kramer, 2009
Money and Inflation
In the last lecture before the midterm, we learned that money is any asset that can easily
be used to purchase goods or services, and then we said that this normally consists of
currency in circulation, checkable bank deposits, and travelers checks.
Two lectures back, we learned that the real interest rate was set in the market for loanable
Here the supply of loanable funds and the demand for loanable funds come
together to determine the equilibrium real interest rate.
Today, we are going to look at how the supply of money and the demand for money
interact and create inflation and the nominal interest rate.
Benefits of Holding Money
If you remember, money is used as a unit of account, a store of value, and a medium of
But you don’t actually need to have any money to use it as a unit of account.
For example, just because you don’t have any dollars, doesn’t mean that you can’t look at
the prices of stuff in dollars.
While money can store value, you don’t have to use money
to store your wealth.
You can store your wealth in things like real estate, stocks, and
However, without money it would be much harder to make payments, and to buy and sell
So the benefit of holding money, i.e. having cash in your pocket or in your
checking account, comes from the fact that you can use it to pay for goods and services.
And the more money that you hold, the easier it is to pay for goods and services.
However, the benefit of each additional dollar diminishes (or goes down).
So if you have
only five dollars in cash, having a sixth would be really useful.
But if you have $5
million, having one more dollar is much less useful.
Cost of Holding Money
Remember that in economics the cost of something is what you give up to get it.
So say I
Now assume that I could hold onto that money as cash or I could invest it in
a mutual fund and earn $5 over the course of the year.
If I hold the $100 as cash, I am
giving up that $5, so that $5 is the cost of holding the money.
In general, the cost of
holding money is the interest that you could have earned if you had invested that money.
One thing to notice is that it is the
interest rate that is the cost of holding money,
not the real interest rate.
This is a little different.
Most of the time when we are looking
at costs and benefits we try to look at real costs and real benefits.
So why are we looking
at the nominal interest rate here?