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Unformatted text preview: sent a change in the price level. Hence, the quantity theory of money implies that the price level is proportional to the money supply. % change in M + % change in V = % change in P + % change in Y. Since we assume that % change in V is 0 and we are presently taking Y as given, the growth in the money supply determines the rate of inflation. Therefore, the central bank, which controls the money supply, has ultimate power over the rate of inflation. If the central bank keeps the money supply stable, the price level will be stable. If it increases the money supply, the price level will rise as well. Government can finance spending by taxes, borrowing from the public (selling bonds), or simply by printing more money by selling bonds to the central bank and having the central bank issue new money to pay for the bonds. Seigniorage is the revenue raised by the printing of money. Printing money to raise revenue is like imposing an inflation tax. The inflation tax is on holders of money as the real value of their money falls. The interest rate that the bank pays is the nominal interest rate, and the increase in your purchasing power is called the real interest rate. If i denotes the nominal interest rate, r the real interest rate, and π the rate of inflation, then this can be written as: r = i – π Rearrange this equation and you get the Fisher equation, which is i = r + π. It shows that the nominal interest rate changes either because the real interest rate or the inflation rate changes. According to the quantity theory, an increase in the rate of money growth of 1% causes a 1% increase in the rate of inflation. According to the Fisher equation, a 1% increase in the rate of inflation causes a 1% increase in the nominal interest rate. The one for one relation between the inflation rate and the nominal interest rate is called the Fisher effect. Page 9 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 Ex ante real interest rate is the real interest rate the borrower and lender except when the loan is made. Since it is based on expected inflation, the ex ante real interest rate is i – πe. Ex post real interest rate is the real interest rate act...
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 Fall '10
 Henriques
 Macroeconomics

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