The two interest rates differ when actual inflation

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Unformatted text preview: ually realized. Since it is determined from actual inflation, the ex post real interest rate is i – π. The two interest rates differ when actual inflation π differs from expected inflation πe. Therefore the Fisher effect is more precisely written as i = r + πe. The nominal interest rate i moves one- for- one with changes in expected inflation πe. The nominal interest rate is the opportunity cost of holding money: it is what you give up by holding money rather than bonds. You could be making the real interest rate r, but instead you are earning a real return of - πe.. Thus, the cost of holding money is r – (- πe), which is i. The quantity of money demanded depends on the price of holding money, therefore the general money demand function is: (M/P)d = L(i, Y). The demand for the liquidity of real money balances is a function of income and the nominal interest rate. The higher is Y, the greater is the demand. The higher is i, the lower is the demand. Since M/P = L(r + πe, Y) (supply of real money balances equals the demand), the level of real money balances depends on the expected rate of inflation. This general money demand equation implies that the price level depends not just on today’s money supply but also on the money supply expected in the future. Expected higher money growth causes expected higher inflation, which through the Fisher effect raises the nominal interest rate, which increases the cost of holding money, decreasing demand for real money balances. Since the central bank has not changed the money supply, this leads to a higher price level. Hence, expected money growth in the future leads to a higher price level today. Costs of expected inflation Shoeleather cost: if people hold lower money balances on average, they must make more frequent trips to the bank to withdraw money. Walking to the bank wears shoes out. Menu cost: changing prices is sometimes costs, for example it may require printing and distributing a new catalogue. The higher the rate of inflation, the more often restaurants have to print menus. Microeconomic inefficiencies: firms facing menu costs change prices infrequently, leading to a high variability in relative prices over the course of the year. Sales will be low at the beginni...
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