Money Market Model Principles Real Or Nominal Interest Rates
Money Market Model Principles Real Or Nominal Interest Rate

Nominal and Real Values

Explain (using graphs as appropriate) how changes in demand and supply in the money market affect the equilibrium nominal interest rate Skill 4.A: Draw an accurately labeled graph or visual to represent an economic model or market. Topic 4.5: The Money Market Learning Objectives: REVIE W. Money market equilibrium occurs at the interest rate at which the quantity of money demanded is equal to the quantity of money supplied. Figure 25.10 “Money Market Equilibrium” combines demand and supply curves for money to illustrate equilibrium in the market for money. With a stock of money (M), the equilibrium interest rate is r.

Dollars and Cents at Different Dates

To compare dollar amounts at different dates, we need to know the CPI on those dates. To convert the price of a good in past dollars (Year 2) to its price in current dollars (Year 1), use the following formula:

Value in Year 1 dollars = {(CPI in Year 1) ÷ (CPI in Year 2)} x Value in Year 2 dollars

Notice that in the above formula, Year 2 does not necessarily have to be greater than Year 1. Thus, the formula works for any two years.⁽¹⁷⁾

Nominal and Real Values in Macroeconomics

The difference between nominal and real variables is important in macroeconomics. In macroeconomics, we generally use the GDP deflator rather than the CPI as our measure of the price level because we are dealing with economy totals, of which consumer spending is just one part.

The calculation of the real wage is similar to the calculation of real GDP, only using a different set of variables. ⁽¹⁷⁾

Real wage = (Nominal wage) ÷ (CPI)

Real GDP = (nominal GDP) ÷ (GDP deflator)

Nominal GDP and Real GDP

Nominal Wage Rate and Real Wage Rate

Money Market Model Principles Real Or Nominal Interest Rates

The nominal wage rate is the average hourly wage rate measured in current dollars and the real wage rate is the average hourly wage rate measured in dollars of a given reference base year.

The real wage rate is the quantity of goods and services that an hour’s work can buy.

Between 1981 and 2011, the nominal wage rate more than doubled, but the real wage rate stayed roughly constant because the increase in the nominal wage rate just kept up with inflation. ⁽¹⁷⁾

Nominal Interest Rate and Real Interest Rate

The nominal interest rate is the percentage return on a loan calculated by using dollars. The real interest rate is the percentage return on a loan calculated by using purchasing power; it’s the nominal interest rate adjusted for the effects of inflation.

Real interest rate = Nominal interest rate – Inflation rate

The calculation of the real interest rate also “deflates” the nominal interest rate. However, because the numbers are already percentages, we must subtract the percentage change in prices (the inflation rate) rather than divide by the price level. When the inflation rate was high, during the 1970s and early 1980s, the gap between the real interest rate and the nominal interest rate was large. The real interest rate was negative in the mid-to-late 1970s and very high in the early 1980s, but has shown no real upward or downward trend since 1971. ⁽¹⁷⁾

Reading: AB, chapter 7, section 4.

Recall, inflation is simply the growth rate of some aggregate price index like the CPI or the GDP deflator. If P(t) denotes the aggregate price level in year t then, symbolically, annual inflation from year t-1 to year t is given as: = %P(t) = (P(t) - P(t-1))/P(t-1).

We build a link between money growth and inflation through our model of money market equilibrium. In money market equilibrium, real money supply is equal to real money demand: M/P = L^d(Y, i). If we assume that the aggregate price level is free to adjust to keep the money market in equilibrium then we can use the money market equilibrium condition to solve for the aggregate price level: P = M/L^d(Y, i). That is, the price level is directly related to the nominal money supply and to real money demand (which is a function of real income and the nominal interest rate).

Using the above relationship between the aggregate price level, nominal money supply and real money demand we may derive a link between inflation, growth in the money supply and growth in money demand. Inflation is just the growth rate of aggregate prices and from the relationship P = M/L^d(Y, i) we get, using the fact that the growth rate of a A/B is equal to the growth rate of A minus the growth rate of B, = %P = %M - %L^d(Y,i). That is, inflation is equal to the growth rate in the nominal money supply (controlled by the Fed) minus the growth rate in real money demand.

Notice that if the growth rate of the nominal money supply is equal to growth rate of money demand then inflation is equal to zero. Now money demand grows over time primarily because the real economy grows over time (average real growth is about 2.5% per year on average). As Y grows individuals consume more and thus need more money to conduct transactions. Since money demand is a function of both Y and i we can use a trick from calculus - the total derivative - to decompose the growth of money demand as follows: %L^d(Y,i) = e_Y*%Y + e_i*%i, where e_Y = income elasticity of money demand and e_i = nominal interest rate elasticity of money demand. Economists estimate that e_Y is approximately 2/3, for the U.S., and that e_i is approximately -1/10 so that money demand is much more sensitive to changes in income than to changes in the nominal interest rate. Further, the growth rate of the nominal interest rate is on average about zero (interest rate on average do not tend to go up or down). These data facts tell us that the nominal interest component does not contribute much to the growth rate of money demand and a reasonable good prediction model for inflation become: = %P = %M - (2/3)*%Y.

An example

Suppose the Fed sets money growth, %M, equal to 6% per year, the annual real economic growth, %Y, is 3% and that the income elasticity of money demand is 2/3. Then our prediction for inflation is given by: = %M - (2/3)*%Y = 6% - (2/3)*3% = 4%.

Empirical relationship between money growth and inflation

The tables below show the relationship between actual inflation and money growth in low money growth countries and high money growth countries.

Inflation in low money growth countries: 1986-1989
Country	money growth (% per year)	inflation (% per year)
Chad	-2.1%	-2.7%
Switzerland	4.1%	1.8%
Belgium	5.0%	1.8%
France	5.5%	3.0%
United States	7.0%	3.6%

Inflation in high money growth countries: 1986-1989
Country	money growth (% per year)	inflation (% per year)
Peru	425%	545%
Yugoslavia	358%	305%
Mexico	71%	82%