Money and Inflation

David Andolfatto
November 2002

1 Quantity Theory of Money

Let us begin our analysis of money and inflation by introducing one of the
oldest economic theories around: the Quantity Theory of Money (QTM). To
begin, I should point out that the Quantity Theory of Money is a misnomer. In
particular, the QTM is not a theory about money at all. Instead, it is a theory
of the price-level (or inflation) which happens to emphasize the role played by
the quantity of money.
Here are the building blocks of the most basic version of the QTM. Let
M t denote the stock of ‘money’ at date t.
Assume that the government (via the
M
monetary authority) has direct control over the supply of money. t is assumed
to be exogenous. Also, suppose that the monetary authority expands the money
µ M µM .
supply at some exogenous rate ; i.e., t = t−1

M .
The theory assumes that there is an aggregate demand for money tD The
idea here is that agents find money useful in facilitating exchanges (making
payments). The assumption is that the more exchanges that are desired, the
more will money be in demand to facilitate these exchanges. This is called the
transactions demand for money. Because the number of transactions is difficult
to measure, some proxy measure is required for empirical work. The traditional
assumption is that the number of transactions is roughly proportional to the
level of economic activity, as measured by (say) the gross domestic product. So,
let Yt denote the level of real GDP at date t and let Pt denote the price-level at
date t. Nominal GDP is then given by Pt Yt. The money demand function can
then be specified as:
MtD kPtYt,
= (1)
where k > is some constant. What equation (1) tells us is that the demand
0

for money is proportional to the level of nominal income.

In the simplest version of the theory, the level of real output Yt is simply
treated as exogenous. By doing so, the theorist is implicitly assuming that
money is neutral (i.e., that monetary factors do not affect anything real in
the economy). Depending on the question at hand, this assumption may or
may not be a reasonable one to make. For now, we will treat Yt as exogenous
and furthermore assume that real output grows at some constant rate γ i.e.,
Y γY − .
;

t = t 1

In the back of your head, you should have in mind the theories that we have
Y γ.
studied in class that explain the determination of t and In particular, for a
given technology and preferences over consumption and leisure, the level of real

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output will be determined by the time-allocation choices made by individuals
(here, it is assumed that such choices are independent of monetary factors).
γ
Likewise, recall that in the Solow model, is determined by the rate of tech-
nological change as well as the rate of population growth (again, both of these
factors here are assumed not to depend on monetary factors).
The final assumption made by the QTM is that the price-level adjusts in
M M .
order to clear the output-for-money market; i.e., t = tD By combining all
of these restrictions, we are able to derive the model’s prediction concerning the
determination of the price-level:

t
M.
P ∗ = kY t
(2)
t

Exercise 1. Explain (provide economic intuition) for how the price-level is in-
fluenced by exogenous changes to money supply and real economic activity.
Exercise 2. Some time in the earlier 1990s, the Russian government announced
that they were planning to switch the national currency from the existing
‘blue’ rouble notes to new ‘green’ rouble notes. All old notes were to be
handed in and exchanged at a prespecified exchange rate. Aside from their
colour, the only difference in the notes was that the new notes had three
less ‘zeros’ on them (i.e., 1000 blue rouble = 1 green rouble). What effect
on the price-level would such a policy be predicted to have according to the
QTM? [Note: the predictions of the QTM were right on the mark in this
case].
Exercise 3. A technological innovation in the economy’s payments system (e.g.,
the arrival of ATMs) might plausibly be modelled as an exogenous decline
in the parameter k. Explain why this may make sense and explain the ef-
fect such an innovation might have on the value of money (the inverse of
the price-level).
Now, since equation (2) holds for all dates t = 1, 2, ..., it follows that the
inflation rate is given by:
∗
Pt+1
= M +1 Y
P M Y +1
t t
∗ (3)

Π∗ = (µ/γ ),
t t t

where Π ≡ P +1 /P
t t is the (gross) rate of inflation.

Exercise 4. Explain (provide economic intuition) for how the inflation rate is
influenced by exogenous changes in the money supply growth rate and the
growth rate in real economic activity.
Exercise 5. On a diagram with time on the horizontal axis and inflation on the
vertical axis, draw the time path for the price-level under the assumption
2
 that µ > γ. Now, at some arbitrary date t0 , imagine that the technological
innovation described in Exercise 3 arrives on the scene. Depict how this
exogenous shock is predicted to alter the time-path of the price-level.
Exercise 6. Identify the set of endogenous and exogenous variables in the QTM.

2 The Fisher Equation

The Fisher Equation is a theory of the nominal interest rate. We have al-
ready studied the theoretical determinants of the real rate of interest within the
context of our two-period general equilibrium model. Recall that the real rate
of interest measures the relative price of output across time. In contrast, the
nominal interest rate measures the relative price of money across time.
One interpretation of the Fisher equation is that it represents a ‘No-Arbitrage-
Condition’ (NAC) which, if violated, would mean that huge profits at zero risk
are available through some very simple bond trades (an arbitrage opportunity
isn’t thought to happen very often or last for very long, which is what motivates
invoking a NAC when examining real world data). So, let’s see how this works.
Consider two types of government securities: a nominal bond and a real
bond (the government of Canada issues both types, although nominal bonds
are far more prevalent). A nominal bond is a debt contract that promises to
deliver some prespecified amount of money at some time in the future. A real
bond is a debt contract that promises to deliver some prespecified amount of
output (or an amount of money with the purchasing power to acquire such
output) at some time in the future. Note that a real bond can be constructed
from a nominal bond by indexing the nominal return to inflation (as is done in
practice). Assume, for simplicity, that both financial instruments are risk-free.
Let R denote the (gross) real return on a real bond; that is, an investment in
one unit of purchasing power today yields R units of output (purchasing power)
tomorrow. Let Rn denote the (gross) nominal return on a nominal bond; that
is, an investment in one dollar today yields Rn dollars tomorrow. The real rate
of return on the nominal bond depends on the rate of inflation and is given
by: Rn /(Pt+1 /Pt ). This expression gives us the purchasing power of the future
dollars that are to be delivered by the nominal bond. The NAC tells us that
the real rate of return on both these instruments must be the same; i.e.,
Rn
R= . (4)
Pt+1 /Pt
Rearranging this expression, we derive the Fisher equation:

Rn = RΠ, (5)

which states that the nominal interest rate is (or should be) equal to the real
interest rate times the rate of inflation.

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Exercise 7. Observe that cash (paper money) is essentially a government bond
with Rn = 1. Explain. Use the NAC in order to derive the real rate of
return on cash.

Note that if one combines the Fisher equation with the QTM, one can pos-
tulate a theory of the nominal interest rate according to:


R = R µγ .
n (6)

Exercise 8. Consider a two-period endowment economy with endowments ( 1 Y ,Y ),

Y γY .
2
where 2 = 1 The economy is populated by a representative agent with
preferences given by MRS c / βc .
= 2 ( 2 ) Assume a closed economy. De-
R
rive the equilibrium real rate of interest ∗ and combine with equation
(6). According to this theory, what are the primary determinants of the
nominal interest rate? In particular, explain why a slowdown in real GDP
growth is unlikely to have much of an impact on the nominal interest rate
(according to this theory).

3 Money Demand Revisited

In the simple version of the QTM described above, we assumed that the demand
for money stemmed solely from a transactions motive. But since money is an
asset (albeit, an asset that pays zero nominal interest), one would expect that
the demand for money might very well depend on the rate of return on other
assets (like interest-bearing government bonds). Why do people hold money
(a zero-interest government bond) when a higher rate of return on bonds (and
other securities) is available? Presumably, the relatively low rate of return on
money is compensated by the liquidity services that money provides. Still, one
would imagine that if the nominal interest rate got to be very high, people
would start to economize on their money balances (and increase their demand
for interest-bearing securities). In this sense, the nominal interest rate represents
the opportunity cost of holding money. We can capture this idea by generalizing
the money-demand function as follows:

M = P L (Y , R ).
D
t t t
n
(7)

The function L(.) represents the demand for real money balances. Since Rn
represents the opportunity cost of holding money, it is reasonable to suppose
that L is a decreasing function of Rn . The function in (1) is just a special case
of (7); i.e., L(Y, Rn ) = kY.
If the demand for real money balances does depend on the nominal interest
rate, then there is an important implication for monetary policy (as embodied
in the parameter µ). In particular, whereas before we saw that monetary policy

4
was neutral (did not influence anything real), we see now that monetary policy
can influence the demand for real monetary balances (and implicitly, other real
quantities). In particular, from (6), we see that a ‘looser’ monetary policy (a
higher µ) will generate a higher inflation and (via the Fisher effect) a higher
nominal rate of interest which, in turn, induces individuals to economize on
their real money balances (e.g., switching to higher resource cost payment in-
struments). Such an effect is likely to impose a significant cost on the economy
for only very high inflation rates, however.

Exercise 9. M φR PY,
Suppose that the demand for money is given by tD = ( n ) t t
φ R.
where is a decreasing function of n Derive an expression for the equi-
µ
librium price-level as a function of . Suppose that the monetary authority
µ.
suddenly announces a ‘tighter’ monetary policy (decrease in ) Explain
the economic consequences of such a change on both the inflation rate and
the current price-level.

3.1 The Velocity of Money

The velocity of an asset is a measure of how quickly that asset circulates. Be-
cause money is designed to serve as primarily as a payment instrument (in
contrast to other assets, that serve primarily as a store of value), one should
expect money to be the asset exhibiting the highest degree of velocity.
The most common measure of velocity is income velocity, which is defined

V ≡ PMY .
as:
t t
t (8)
t

For the money demand function specified in Exercise 9, income velocity reduces
to:
V = φ(R1 ) .
t n

Since φ is a decreasing function of R , the theory predicts that velocity is in

n

an increasing function of the nominal interest rate, which is broadly consistent

with the evidence; see Figure 9.19 in Williamson (pg. 361).

3.2 Limitations of the QTM and the Fisher Equation

The QTM and the Fisher equation possess two great virtues. First, they are
simple and compelling theories of inflation and the nominal interest rate, re-
spectively. Second, over long periods of time and in cross sections of countries,
their predictions are not terribly inconsistent with the evidence.
Unfortunately, both theories are considerably less consistent with the ‘short-
run’ evidence. In particular, the prime determinants of short-term nominal
interest rates do not appear to include long-term forecasts of inflation (or money

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growth). In addition, unexpected changes in the stock of money (or the money
growth rate) appear to be associated with changes in real economic activity.
From a theoretical point of view, the QTM also leaves much to be desired.
To begin, the theory assumes that the monetary authority has direct and com-
plete control over the money stock. In reality, the monetary authority has such
control only over the monetary base (the stock of small denomination govern-
ment paper notes and coins in circulation). Empirically, the stock of money in
an economy is mostly made up of electronic transactions credits that are created
by private chartered banks. (These credits circulate across the accounts of indi-
viduals who are linked to the banking sector, for example, by way of a chequing
account). From a theoretical point of view, it seems unreasonable to interpret
a change in the supply of private money (e.g., demand deposits) simply as an
‘exogenous shock’. It seems more reasonable to suppose that the supply of pri-
vate money reacts to other exogenous shocks in the economic environment. For
that matter, many economists have noted that the supply of base money might
also be better modelled as responding to other economic variables, as opposed
to being interpreted as a source of economic disturbance.
The QTM is also silent on the issue of how new money is injected into the
economy. In principle, the method of injection is likely to matter. In practice,
central banks typically inject money into the economy by purchasing government
securities (open market operations). This aspect of monetary policy is absent in
the QTM; e.g., it makes no difference whether new money is injected via an open
market operation or whether new money is simply distributed via ‘helicopter
drops.’ The QTM also ignores how monetary policy interacts with fiscal policy.
Whether these omissions are relevant is, of course, an empirical matter. But
because the QTM cannot deliver plausible explanations for many important
episodes in monetary history, one could perhaps argue that these omissions are
important.