Macroeconomics EC2065 CHAPTER 6 - MONEY AND MONETARY POLICY

EC2065 MACROECONOMICS
CHAPTER 6: MONEY AND MONETARY POLICY

Learning outcome:
By the end of the chapter, you will be able to address the following questions:
• Why has the link between money supply growth and inflation been unstable?
• What advantages do governments derive from being able to create money?
• What are hyperinflations and why are they so damaging?
• How should central banks conduct monetary policy?
• Is it better to have a monetary system without physical cash?
• Can and should nominal interest rates ever be negative?
• How do cryptocurrencies differ from existing forms of money?
Essential readings:
Williamson, Chapters 12 and 18.
Introduction:
Up to this point, our study of macroeconomics has focused only on real variables. In ignoring
any reference to money, we have implicitly assumed individuals do not suffer ‘money
illusion’ and that they are able to make decisions solely with reference to real values and
relative prices. But are there reasons why money matters that are missing from our earlier
analysis? In other words, why is money important for the functioning of markets?
1. Why Does Money Matter?
• There are three reasons why money matters and they are:
1. Money is used as a means of payment. Trade between individuals and firms in the
economy depends on having an object such as money that serves as a medium of
exchange.
2. Money matters is due to ‘nominal rigidity’. Some market prices are quoted in units of
money and slow to adjust, or are set in contracts that are renegotiated only
infrequently.
3. Changes in the value of money affect the willingness of individuals to hold money.
• The reasons that money matters in an economy are closely related to the three
functions of money: medium of exchange; unit of account; and store of value.
PREPARED BY CHEN AIDI 1

• Money functions as a medium of exchange because money is accepted as payment

for goods and services. Direct barter exchange of different goods, or of labour for
goods, is inconvenient and difficult.
• Money functions as a unit of account as it is convenient to quote prices in terms of

money instead of relative prices among a huge range of different goods. Money is
also the conventional unit of account used to specify wages in employment contracts
and repayments in debt contracts.
• Money functions as a store of value as money is an asset that can be used to transfer
purchasing power over time. However, all assets act as stores of value, so this
function is not particular to money.
• We will focus on the two special functions of money, medium of exchange and
unit of account, with most of this chapter devoted to money as a medium of
exchange.
Medium of Exchange:
• The medium of exchange function of money arises from the problem of the absence
of a double coincidence of wants.
• A double coincidence of wants occurs when both person A and person B have a good
that the other person wants. In a specialised economy producing a vast range of goods
and services, a double coincidence of wants is rare.
• For trade to take place in markets, it must be in interests of both parties. Since double
coincidences of wants are hard to find, barter exchange is difficult.
• Exchange is made easier if one party is willing to accept money because then trade
requires only a single coincidence of wants where person A wants a good person B has
but person B does not want any good that person A has.
Unit of Account:
• The unit of account function of money results from there being too many relative
prices to quote directly among all the different goods and factors of production in an
economy.

• It is convenient to express all prices as amounts of money. Similarly, in contracts

written to govern long-term employment and creditor-debtor relations, it is
convenient to specify payments in terms of a conventional unit of account.
Different Objects That Serve As Money:
• The common forms of money in use today are notes and coins issued by
governments or central banks that do not have intrinsic value, i.e. they are not
valued for the material from which they are made. This type of money is known as
‘fiat’ currency.
• The other type of money commonly in use today is deposits at commercial banks.
These deposits are claims to fiat currency, so this a type of ‘credit’ money.
Commercial banks themselves hold fiat money as vault cash or reserves at the
central bank, which is another form of fiat money.
• There are also some new or experimental forms of money that are yet not in general
use but may become more widespread in the next decade. These include
cryptocurrencies, which are a private and decentralised system of money (without
central bank intervention).
• Central banks also have plans to set up central-bank digital currencies, which are a
centralised system of accounts where individuals hold money directly at a central
bank.
• Historically, money took other forms that are now extremely rare. These include
commodity money, where coins are made from precious metals, or notes issued by
the government were redeemable for precious metals on demand. There were also
private bank notes, a form of credit money, which were claims to commodity money.
2. A Search Theory Perspective On Money:
• To understand the medium of exchange function of money, the assumption was that
everyone can buy or sell in markets subject only to a budget constraint. The
sequence of transactions was irrelevant – all that mattered was that each person’s
overall budget constraint was satisfied.

• However, unless there is a double coincidence of wants for all trade, this implicitly
assumed a very high degree of coordination, or that short-term credit is freely
available and works without any friction. The reason is that a budget constraint
allows for purchases in a period even though people may not have yet received
payment for what they plan to sell.
• An alternative approach is known as ‘search’ theory. In a search model, all trade is

decentralised and occurs in meetings between pairs of individuals rather than in
centralised markets.
A Simple Search Model of Money:
• The idea of the search theory can be illustrated using a simple model with three
types of individuals. Think of these individuals as having different occupations, so
that they specialise in producing different goods.
• Moreover, individuals have different needs and tastes, so their preferences are not
the same. We assume no double coincidences of wants to highlight the usefulness of
money.
• A specific example of the three individuals is given in the figure below:
• In a search model there are no competitive, centralised markets. All trade must be
bilateral, meaning that it takes place between pairs of individuals. To keep the
analysis simple, assume only one indivisible unit of each of the goods and services
can be produced. This avoids the need to discuss prices at this stage because any
trade that takes place must involve one unit of goods being purchased or sold.

• In the absence of any double coincidence of wants, no trade can take place between
any pairs of individuals. However, this is inefficient. If all three individuals could meet
and coordinate a three-way exchange centrally then all three could have their wants
met by one of the others.
• In the example above, everyone produces a service, which cannot be stored. Once
we allow for physical goods, it is possible that one or more such goods can become a
commodity money.
• A commodity money has intrinsic value because of what it is made of, so it would
have a value even if it were not used as money. But, crucially, a commodity money is
accepted for payments even by those who do not want to consume the commodity
itself. Examples of commodity money are gold, silver and precious metals.
• The figure below modifies the earlier example so that one person can produce a
physical good and one person wants to consume that good. However, there is still no
double coincidence of wants for direct barter exchange. But all trade is possible if
everyone accepts the physical good in exchange for what they produce even if they
do not want to consume it. This enables the physical good to serve as a commodity
money.
• For a good to serve as a commodity money, it should be:

1. Easily storable at low cost, potentially for long periods of time
2. Easily transportable
3. Straightforward to verify the quality of the good
4. Easily divisible, for when exchange is not one-for-one.
In the above example, cake is assumed to be the commodity money.

• In the past, precious metals were a common form of commodity money, which
satisfy the first two of these requirements well. The use of coinage and convertible
notes or tokens added extra convenience, helping to satisfy the third and fourth
requirements.
• The advantage of a system of commodity money is that the limited supply and
intrinsic value of the commodity should give confidence that money will be a good
store of value, or at least not too bad.
• The disadvantage of a system of commodity money is that the system ties up

valuable goods as money, which either cannot be used directly, or there must be
extra production of the commodity, which has a cost. (However, gold actually have
other uses. Gold can also be used as jewellery directly by people)
Credit Money:
• An alternative to a system of commodity money is to use credit money.
• Credit money is where privately issued IOUs circulate as money. An IOU is a debt i.e.
a promise to deliver a payment in the future.
• The intended purpose of an IOU is a simple credit instrument, where, say, person A
offers an IOU to person B in exchange for something, which is accepted. Person A
then later redeems the IOU, giving person B what is owed.
• But IOUs could in principle become money if the initial holder uses it to make a
payment to someone else and then that person might pass it on to someone else as
well. Consequently, the IOU is held by a third party at redemption.
• An example of IOU is the government bonds where households can use government
bonds as collaterals when they borrow from commercial banks.

• The figure below returns to the example with three individuals who produce only
services. Since services must usually be consumed at the point they are produced,
this rules out the use of commodity money. However, if everyone is willing to accept
someone’s IOU, that IOU can circulate as money. Through the use of this credit
money, all three individuals are able to purchase the services they desire.
Money And Credit:
• The example of a private IOU circulating as money shows that there is often a
connection between money and credit. However, it would be a mistake to see
money and credit as the same thing.
• First, not all types of money are credit. For example, in the example with commodity
money, no-one owes anything to anyone else. As we will see, fiat money is also not a
debt that the government is obliged to repay.
• Second, far from all credit ever becomes money. Very few individuals are sufficiently
well known that their IOUs could circulate as money. To use an IOU as credit money,
everyone who would subsequently hold the IOU needs to know and trust the issuer,
in addition to the first person to accept the IOU, which is all that would be required if
the IOU were used as a simple credit instrument. Only in the smallest communities
are these requirements likely to be met for circulation of individuals’ own IOUs.
• Considering these difficulties, for credit to serve as money, the IOUs need to be
issued by large, well-known and trusted companies or organisations. In practice, this
means banks.

• Historically, bank IOUs took the form of their own issue of banknotes, which were
promises to repay deposits of commodity money. In the modern world, bank IOUs
typically take the form of deposits, which are claims to fiat money.
• If banks have created IOUs that are accepted for payments then it is easy to see how
these can be used to facilitate exchange among the three individuals in the earlier
example. Thus, trade can take place using credit money issued by banks even if the
individuals in the economy cannot persuade others to use their own IOUs as money.
• A system of credit money has some important advantages:
1. It is efficient system with a low resource cost because it does not tie up goods with
intrinsic value to be used as money.
2. Even if bank IOUs are claims to commodity money, banks would not need to hold
100 per cent of deposits as vault cash with intrinsic value. Banks can loan deposits to
support long-term investment. Some of the return on these investments can be paid
to depositors as interest, making bank deposits a better store of value.
• The disadvantages of credit money are:
1. Default by banks on their IOUs may cause a collapse of confidence in the monetary
system. Bank runs and bank failure disrupt trade and trigger financial crises.
2. Defaults by banks may be due to losses made on their loans, or even caused by a bank
run itself. These problems also lead to pressure for bailouts from the government,
creating a problem of moral hazard (‘too big to fail’).
• Individuals’ own IOUs cannot circulate as money. However, it is possible that some
forms of credit can be substitutes for money in making payments, for example,
credit cards.
• An individual paying with a credit card does not need to hold money at the time of
making a purchase, hence, this payment method acts as a substitute for money.
Essentially, the financial intermediaries that issue credit cards endorse individuals’
IOUs so others can be assured these debts will be repaid. The ability to use credit in
this way reduces frictions in payment because there is less need to hold money. In
this case, credit card can been seen as a medium of exchange and not a means of
payment.

• However, such a system of credit-based payments has costs for financial

intermediaries coming from the need to track credit histories and collect debt
repayments.
Fiat Money:
• Another form of money in widespread use is fiat money. This is defined as

government-issued money of no intrinsic value.
• The term ‘fiat’ suggests this money has value by government decree but that is
misleading because ultimately the real value of fiat money is determined in markets.
• Fiat money is not credit money because it is not a claim to anything other than itself
– it is not redeemable as an IOU is. Historically, government-issued notes may have
been claims to commodity money but this is no longer the case.
• In accounting terms, fiat money is recorded as a liability of the government or

central bank but it is important to remember that is quite unlike private-sector
liabilities such as bonds or loans. ( Recall the Central Bank’s balance sheet)
• The physical form of fiat money is cash, comprising notes and coins of non-precious
metal.
• Commercial banks hold some fiat money as vault cash but in modern monetary
systems, the reserves of commercial banks are usually held in accounts at the central
bank.
• In this form, fiat money is only an entry in a database recording how much each
commercial bank has on ‘deposit’ in its reserve account at the central bank. While
currently households and firms do not hold reserves directly, commercial banks can
convert reserves and cash one-for-one.

• The figure below shows how trade can take place using fiat money in the earlier
example with three individuals:
• Initially, someone holds a unit of fiat money and everyone accepts it for payments.
The fiat money circulates among the individuals and everyone can consume the
service they desire. Note that the fiat money remains in circulation after all the
exchanges have taken place. This implicitly assumes the fiat money will go on being
used for future trade.
• Fiat money shares the advantage of credit money in being an efficient, low-cost
system because the intrinsically worthless money that is used has a negligible
resource cost (there are still some costs of production for the notes and coins, and
costs of handling cash for the private sector). It is important that individuals can
easily recognise units of fiat money as genuine but this can be achieved to a
sufficient degree of accuracy with appropriate anti-forgery devices.
• The potential disadvantages of fiat monetary systems also stem from fiat money
lacking any intrinsic value. As currency has a much lower cost for the government to
produce it than its market value and, as there is no obligation to redeem it, there is a
temptation to issue more fiat currency to raise revenue. The abuse of this money-
issuing power by governments results in money being a poor store of value and, at
worst, hyperinflation.

• Furthermore, because fiat money is not redeemable for anything other than itself,
its value depends on the belief that others will continue to accept it for payments.
Note that in the figure above, the fiat money is never withdrawn from circulation.
This means that those choosing to accept money must always believe that others
will continue to accept money in the future. In principle, such beliefs could be
subject to self-fulfilling shifts because the belief that others will not accept fiat
money justifies individuals choosing not to accept it.
• However, in practice, the concern about self-fulfilling losses of confidence in fiat

currency may be mitigated by the government’s power of taxation. Governments
can insist on payment of taxes in their own currencies, which ensures there is always
some demand for money. The payment of taxes in fiat money to the government
could also be seen as a mechanism through which fiat money is withdrawn from
circulation.
Box 6.1: Cryptocurrencies:
• Recent years have seen a rise to prominence of cryptocurrencies, most famously

Bitcoin, but now many others too. Cryptocurrencies are a type of privately created
money in an electronic form. The operation of cryptocurrencies is a decentralised
system, unlike the centralised control of fiat money by governments.
• Nonetheless, cryptocurrencies share some features of fiat money. They have no

intrinsic value, which makes them very different from commodity money.
Cryptocurrencies are also not IOUs in any sense, which means they are not credit
money.
• Proponents of cryptocurrencies have put forward several advantages namely:
1. The blockchain technology they build on makes transactions very secure.
2. Because the supply of a particular cryptocurrency is limited by design, it is argued

there is less risk of the cryptocurrency losing value due to oversupply – in contrast to
fiat money where governments have discretion to create more – making
cryptocurrencies a better store of value. However, limited supply is necessary but
not sufficient to preserve value, which also depends on a stable or growing demand
for a currency.

• Critics of cryptocurrencies argue there are serious disadvantages namely:
1. The value of a cryptocurrency depends on others’ beliefs about its future value,
which risks significant volatility (in theory, this is also a drawback of fiat money).
Values of cryptocurrencies have indeed been extremely volatile, making them far
from a traditional risk-free asset.
2. As with cash, the anonymity allowed by cryptocurrencies may facilitate criminal

activity, although this anonymity might also be valuable in fostering civil liberties.
3. There is the cost of the computing power used to maintain the distributed ledger,
implying that cryptocurrencies may entail significant resource costs, a disadvantage
shared with commodity money.
How do cryptocurrencies fit into our analysis of money?
• We will usually think of money as an asset that serves as a medium of exchange but
which is less good compared to other assets as a store of value.
• But cryptocurrencies are currently little used as a traditional medium of exchange –

not many purchases of goods and services use cryptocurrency. Cryptocurrencies
have had high (although volatile) rates of return, unlike traditional forms of money.
• In light of these observations, it may be better to think of people holding

cryptocurrencies as a financial asset rather than as money in the usual sense of the
term. With no dividends and all returns coming from capital gains, one approach to
analysing cryptocurrencies is as ‘bubbles’ in the overlapping generations model.
3. Money and Assets As Stores of Value:
• Storing value is a function of money but this function is not unique to money. All
assets must act serve as stores of value to some extent and many often do this
better than money.
• For example, bonds may offer a real return 𝑟 from interest payments, shares pay
dividends, property earns rents and shares and property may benefit from capital
gains.
• Considering money, let 𝑖𝑚 denote the return on holding money for a period in terms
of units of money itself. For example, if money is interpreted as funds in a bank
account, 𝑖𝑚 is the interest rate paid on deposits.

• If money is cash for which no interest is paid then 𝑖𝑚 = 0. Note that 𝑖𝑚 is a nominal
interest rate and a nominal return: it is the percentage increase in the amount of
money held simply by holding on it for some amount of time.
• The terminology we will use throughout this chapter is that nominal refers to
something measured in units of money, while real refers to something measured in
units of goods.
If the nominal return on money is 𝒊𝒎 , what is the implied real return?
• The real return on money, and nominal assets more broadly, depends on the
inflation rate in the economy. (Think of the Fisher equation)
Inflation:
• Inflation is defined as a general rise in prices quoted in terms of money. Inflation

affects how good or bad money is as a real store of value.
• Let 𝑃 denote the price of this good, or basket of goods, in terms of units of money. If
the price level in the current period is 𝑃, the notation for the price level in the next
period is 𝑃′. The rate of inflation between these time periods is denoted by 𝜋:
𝑷′ − 𝑷
𝜫=
𝑷
Note that this definition of inflation refers to the percentage change in prices
between the current level and the level that will prevail in the future.
• It is also possible to measure inflation between the past and current periods and
where that inflation rate is relevant, the notation will be adjusted to accommodate
it. Note also that the future price level 𝑃′ and the resulting inflation rate are not
known in current period. Where the distinction between and expected inflation is
important, the notation 𝛱 𝑒 will be used to denote expected inflation.

• In the following figure, it shows data on inflation for the USA in the post-war period:
• Observing from the figure above, inflation is volatile at the end of the 1940s but
becomes very low and stable in the 1950s. The 1960s see an increase in the inflation
rate, which reaches double digits in the 1970s. Inflation is brought under control in
the 1980s and remains stable throughout the 1990s. This stability continues into the
2000s except for the years around the 2007–8 financial crisis and its aftermath.
• To calculate the real change in spending power when holding money, the value of
money, plus any interest 𝑖𝑚 that accrues, is adjusted for changes in the money prices
of goods and services. Take the amount of money 𝑃 that currently buys one unit of
goods. If held simply as money then this becomes (1+𝑖𝑚 )𝑃 units of money in the
future period and with a price level P’, it would be possible to buy (1+𝑖𝑚 )𝑃/𝑃′ units
of goods in the future.
• The definition of the real return 𝑟𝑚 on money is that holding an amount of money
sufficient to purchase a unit of goods now yields purchasing power over 1+ 𝑟𝑚 units
of future goods. The percentage real return on money 𝑟𝑚 is therefore calculated
from the equation:
(1 + 𝑖𝑚 )𝑃 1 + 𝑖𝑚 1 + 𝑖𝑚
1 + 𝑟𝑚 = = ′ =
𝑃′ 𝑃⁄ 1+𝜋
𝑃
1+𝑖𝑚
Hence, 1 + 𝑟𝑚 = 1+𝜋

• Observe that (1+ 𝑟𝑚 )(1+𝜋) = 1 + 𝑖𝑚 implies 1+ 𝑟𝑚 + 𝜋+ 𝑟𝑚 𝜋= 1 + 𝑖𝑚 . If 𝑟𝑚 𝜋 is small

compared to 𝑟𝑚 and 𝜋, the real return on money is approximately given by 𝑟𝑚 ≈ 𝑖𝑚
− 𝜋. In the case where no interest is paid on money (𝑖𝑚 =0), for example, when
money is interpreted as cash, then the real return is approximately 𝑟𝑚 ≈ −𝜋. This
says that the inflation rate is approximately the percentage loss of purchasing power
of money over time.
The Fisher Equation:
• The equivalent calculation of the real return on holding nominal bonds is known as
the Fisher equation. A nominal bond is one that specifies payments in terms of units
of money. It is natural for bonds to make payments in this form following on from
our earlier discussion of money’s role as a unit of account.
• Suppose that a nominal bond makes a single payment of interest in terms of money
in the next period and this payment is certain. The interest rate specified by the
bond is 𝑖, the nominal interest rate and nominal return on holding the bond. This is
known when the bond is purchased. The substantive assumption here is that the
bond payment is not indexed to inflation.
• The Fisher equation gives the implied real return, referred to as the real interest rate
𝑟:
(1 + 𝑖)𝑃 1+𝑖
1+𝑟 = ′
=
𝑃 1+𝛱
The justification for this equation is that one unit of goods costs 𝑃 units of money in
the current period. If this money is used to buy bonds that offer a nominal interest
rate 𝑖, the amount of money returned when the bond matures in the next period is
(1+𝑖)𝑃. Dividing this by the future price level 𝑃′ gives the amount of future goods
that can be purchased. The equation then follows by noting that 𝑟 is defined so that
buying nominal bonds worth a unit of goods today gives the ability to buy 1+𝑟 units
of goods in the future.
• Rearranging the equation gives 𝑖= 𝑟+𝜋 +𝑟𝜋, so if 𝑟 and 𝜋 are small, the term 𝑟𝜋 is
negligible compared to the other terms, and it follows that 𝑟≈ 𝑖− 𝜋. This equation,
which can also be written as 𝑖 ≈ 𝑟+ 𝜋, is the approximate version of the Fisher
equation.

• The Fisher equation states that the real return on bonds is the difference between
the nominal interest rate and the inflation rate. This is an approximation, and in
contexts where the inflation rate can be very high, the exact version 1+𝑖 =(1+𝑟)(1+𝜋)
will be used.
Ex-Ante and Ex- Post Interest Rates:
• Inflation affects the real return on nominal assets such as money and nominal bonds.
However, inflation 𝜋 as defined earlier is the percentage change in the price level
between the current and future time periods, which is therefore not known in
advance. This means the Fisher equation can be used with either actual inflation 𝜋 or
expected inflation 𝜋 𝑒 as appropriate.
• Using the expected inflation rate 𝜋 𝑒 leads to an expected (ex-ante) real interest rate
𝑟 𝑒 ≈ 𝑖− 𝜋 𝑒 , or by giving this equation in its exact form, 1+ 𝑟 𝑒 =(1+𝑖)/(1+ 𝜋 𝑒 ). Using the
actual inflation leads to the actual (ex-post) real interest rate 𝑟 ≈ 𝑖− 𝜋, or in its exact
form, 1+𝑟 = (1+𝑖)/(1+𝜋).
• Different from nominal bonds, inflation-indexed bonds have the same actual and
expected real returns. This type of bond is sometimes referred to as a real bond to
distinguish it from bonds that specify payments in terms of fixed amounts of money
The opportunity cost of holding money:
• Money provides an important service in facilitating transactions as a medium of

exchange. Despite this advantage, money generally performs less well as a store of
value than other assets.
• To the extent that the return on holding money is below the return on alternative
assets, there is an opportunity cost of holding money that must be set against its
benefits in facilitating transactions. This opportunity cost is inversely related to how
well money performs as a store of value.
• We will take nominal bonds as the alternative asset to which money is compared.
The nominal interest rate on bonds is 𝑖, which is also the nominal return on holding
bonds. If money pays interest at nominal rate 𝑖𝑚 then the relative return on bonds
compared to money is the difference between the interest rates 𝑖− 𝑖𝑚 . Note that this
relative return is the same if calculated as a comparison of real returns 𝑟 and 𝑟𝑚
because the same inflation rate 𝜋 is subtracted from both:
𝒓 − 𝒓𝒎 = (𝒊 − 𝜫) − (𝒊𝒎 − 𝜫) = 𝒊 − 𝒊𝒎

• The opportunity cost of holding money is therefore 𝑖𝑖−𝑖𝑖𝑚𝑚. As we will see, the
opportunity cost is usually positive, with holders of money forgoing a generally
higher return on bonds.
• If no interest is paid on money (𝑖𝑚 =0), for example where money is physical cash,
then the opportunity cost is simply 𝑖𝑖. In this case, the level of nominal interest rates
on bonds is a measure of the opportunity cost of holding money.
Real And Nominal Interest Rates:
• In the earlier analyses of consumption, saving, and investment in Chapter 3 shows

that it is the (expected) real interest rate 𝑟 that is important for incentives. For
example, the theory of investment links the real interest rate to the marginal
product of capital net of depreciation.
• We have seen there are reasons to believe that real interest rates should be positive
on average if the productivity of capital is sufficiently high, or households are
impatient. But theory does not rule out times when real interest rates are negative.
• A time series of US real interest rates is shown in the figure below:
• From the figure above, this shows that real interest rates are positive but low on
average (around 2 per cent). The 1980s featured much higher real interest rates,
which peaked at close to 10 per cent. Real interest rates were positive but lower in
the 1960s and the 1990s. There are also times of negative real interest rates in the
late 1940s, 1970s and, more recently, from the aftermath of the 2008 financial crisis
through to 2021.

• The nominal interest rate also matters independently of the level of real interest
rates. This is because it affects the relative returns on money and bonds in a world
where at least some forms of money pay no interest, which influences how
households allocate wealth between different assets.
• Empirically, US nominal interest rates have almost always been positive, though
there have been long spells where they have been close to zero, most notably after
the 2008 financial crisis. On average, nominal interest rates are higher than real
interest rates, reflecting the positive average rate of inflation. The broad pattern for
US nominal interest rates is that they were very low in the 1940s, increased over the
subsequent decades to peak close to 15 per cent in the early 1980s and then
declined in through to the time of writing (2021).
• Nominal interest rates are clearly positive on average, indicating a positive

opportunity cost of holding money, particularly cash. In some countries, nominal
interest rates have occasionally turned negative.
4. The Demand for Money:
• The basic trade-off is that money facilitates economic activity by acting as a medium
of exchange but may not be so good as a store of value compared to alternative
assets.
• So, while money is useful to households and firms, they have incentives to
economise on holding money, use alternatives to money, or carry out fewer
transactions.
• Suppose that real GDP 𝑌 is an indicator of the number of transactions taking place in
an economy and each transaction requires using a means of payment such as
money. Here, we take the level of real GDP 𝑌 as given, returning later to the
question of whether that is affected by money and monetary policy. If the price level
is 𝑃, the money value of all transactions in the economy is 𝑃𝑌.
• To represent the role of money as a medium of exchange, we impose the following

transaction constraint in addition to the budget constraints faced by agents in the
economy:
M ≥ P(Y-X)
• This constraint specifies a minimum level of money that households and firms must hold
to carry out transactions.

• Mathematically, it requires that the level of money holdings on average during a

period is sufficient to pay for transactions of real value 𝑌−𝑋, which correspond to an
amount of money 𝑃(𝑌−𝑋). The variable 𝑋 has several possible interpretations,
including efforts to economise on holding money or use alternatives to money in
carrying out transactions.
• Assume that money pays no interest. Holding money balances 𝑀 on average during
a period means forgoing interest 𝑖 that could have been earned from holding bonds
instead. If money pays interest at rate 𝑖𝑚 , all we need to do is replace the
opportunity cost 𝑖 with 𝑖− 𝑖𝑚 throughout this chapter.
• Taking as given 𝑃 and 𝑌, the minimum amount of money holdings consistent with
the transaction constraint can only be reduced and thus forgone interest saved, by
increasing 𝑋. As we now discuss, increasing 𝑋 has costs that we can compare to
forgone interest to derive households’ and firms’ demand for money.
Economising On Holding Money:
• The first interpretation of 𝑋 is efforts to economise on the amount of money held on

average. All 𝑃Y transactions are carried out with money but agents make frequent
exchanges between bonds and money to keep their average holdings of money
lower. Consequently, as 𝑋 rises, average holdings of money 𝑀 fall further below 𝑃Y.
• The benefit of higher 𝑋 is a reduction in forgone interest but this uses up time or
incurs transaction costs. These costs in real terms are specified by the function 𝑍(𝑋),
which is increasing in 𝑋. We assume 𝑍(𝑋) has the properties 𝑍(0)=0, 𝑍′(𝑋)>0, and
𝑍′′(𝑋)>0, the third of these implying that the marginal cost 𝑍′(𝑋) is increasing in 𝑋.
• Conditional on 𝑋, the lowest money holdings can be is 𝑀=𝑃(𝑌−𝑋). An increase of 𝑋

by 1 reduces the need to hold real money balances 𝑀/𝑃 by 1, which reduces the real
value of forgone interest 𝑖M/𝑃 on money holdings by 𝑖. The marginal benefit of
higher 𝑋 is thus equal to 𝑖. The marginal cost of higher 𝑋 is Z’(𝑋), which we will
denote by 𝑞 in what follows. The optimal choice of 𝑋* is where the marginal benefit
equals the marginal cost:
i = Z’(X*)

• The marginal cost function 𝑍′(𝑋) is shown as an upward-sloping line in the graph below
with 𝑋 on the horizontal axis and the marginal cost 𝑞 on the vertical axis:
• The optimal value of 𝑋* for a particular nominal interest rate 𝑖 is derived by drawing
a horizontal line at 𝑞=𝑖 and finding where it intersects the marginal cost function.
The figure shows that a higher nominal interest rate 𝑖 leads to an increase in the
optimal 𝑋*. Intuitively, if money is a worse store of value, meaning that the
opportunity cost 𝑖 is higher, it is rational to make more efforts to avoid holding it.
• Having derived 𝑋*, agents’ demand for money 𝑀𝑑 is the minimum amount allowed
by the transaction constraint (assuming 𝑖>0, so there is a positive opportunity cost):
𝑀𝑑 = 𝑃[𝑌 − 𝑋 ∗ (𝑖)]
This a money demand function of the form 𝑀𝑑 =𝑃L(𝑌, 𝑖), where real money demand
𝐿(𝑌, 𝑖)=𝑌−𝑋 ∗ (𝑖) is increasing in 𝑌 and decreasing in 𝑖.
• The choice of how much money to hold is related to the following measure of the
velocity of money 𝑉, which is defined by 𝑀𝑉=𝑃Y. This is a measure of how fast a unit
of money circulates in a given period as it is used for multiple transactions. Since
𝑉=𝑃Y/𝑀𝑑 =𝑌/[𝑌 − 𝑋 ∗ (𝑖)], velocity is inversely related to 𝑀𝑑 and increases with the
opportunity cost 𝑖 of holding money. Intuitively, money circulates faster with people
holding it for shorter periods when money is a poor store of value.

Alternatives To Money:
• A second interpretation of 𝑋 in the transaction constraint 𝑀+𝑃X ≥𝑃Y is using

alternatives to money as a means of payment.
• In the earlier part of the chapter, we have also discussed how credit might be used
as a substitute for money in some situations. Suppose banks offer credit facilities, for
example, credit cards and let 𝑋 now denote the real value of transactions paid for
with credit. Think of this as short-term credit, with borrowing during a period repaid
at the end of the period. A fee 𝑞 is charged for using credit as a fraction of the
amount borrowed.
• In offering credit, banks face costs of screening borrowers and collection of debts.
Assume that these costs are an increasing function 𝑍(𝑋) of 𝑋. In addition, the
marginal cost Z’(𝑋) of extending provision of credit is increasing in the amount of
borrowing 𝑋. This represents the idea that banks would face higher costs when they
expand lending to a wider group of less credit-worthy borrowers, or extend more
credit to existing borrowers.
• Assuming the banking system is competitive, banks offer credit 𝑋 𝑠 up to the point
where the fee charged 𝑞 is equal to the marginal cost 𝑍′(𝑋):
q= Z’(𝑋 𝑠 )
This yields an upward sloping supply curve 𝑋 𝑠 (q) for credit facilities.
• Consider the demand for credit by households and firms as a means of payment.
Transactions can equally well be carried out using credit facilities or using money.
The credit facility fee is 𝑞 per unit of spending is the cost of using credit for
payments. If money is used instead then the cost is the opportunity cost 𝑖 of holding
money.
• Since the two means of payment are perfect substitutes, if 𝑞 < 𝑖 then payment with
credit facilities is preferred, if 𝑞 > 𝑖 then payment using money holdings is preferred,
and if 𝑞= 𝑖 then everyone is indifferent between the two. It follows that the demand
for credit facilities 𝑋 𝑑 (𝑞) is perfectly elastic in the range 0≤ 𝑋≤ 𝑌 with respect to the
fee at 𝑞= 𝑖.

• The demand function 𝑋 𝑑 (𝑞) is plotted alongside the supply function 𝑋 𝑠 (q) in the
diagram below:
• The demand curve shifts vertically if the nominal interest rate 𝑖 changes, moving
upwards if 𝑖 rises. The equilibrium of the market for credit facilities is at the
intersection of the demand and supply curves. Assuming 𝑋 ∗ < 𝑌, so some amount of
money is held to make payments, the equilibrium features 𝑞*= 𝑖, so the credit fee is
equal to the nominal interest rate on bonds.
• An increase in 𝑖 shifts the demand function upwards, so the equilibrium 𝑋 ∗ (𝑖) rises
with 𝑖. As it does not make sense to hold more money than required to satisfy the
transaction constraint when 𝑖 >0, the money demand function is 𝑀𝑑 =
𝑃[𝑌 − 𝑋 ∗ (𝑖)], which has the same form as seen earlier with the first interpretation
of 𝑋.
The Money Demand Function:
• Considering 𝑋 as either effort to economise on holding money, or substitution

towards alternatives to money, the resulting money demand function has the form:
𝑀𝑑 = 𝑃𝐿(𝑌, 𝑖)
• The function 𝐿(𝑌, 𝑖)=𝑌−𝑋 ∗ (𝑖) for holdings of real money balances 𝑀𝑑 /𝑃 increases in 𝑌
and decreases in 𝑖. Nominal money demand 𝑀𝑑 is proportional to the price level 𝑃 for
given real transactions and interest rates because higher prices scale up the need for
units of money to make payments.

• Money demand 𝑀𝑑 increases with 𝑌 as higher GDP means more transactions. Money
demand 𝑀𝑑 decreases with 𝑖 because a higher opportunity cost increases incentives to
reduce money holdings through various means.
• The money demand function is plotted against the price level 𝑃 in the left panel of the
diagram below for given values of real GDP 𝑌 and the nominal interest rate 𝑖:
• It is an upward-sloping straight line because nominal money demand is proportional

to the price level. The demand function pivots to the right if 𝑌 increases or 𝑖 falls.
• The relationship between the nominal interest rate 𝑖 and real money demand 𝑀𝑑 /𝑃
is depicted in the right panel of the diagram above. The negative relationship reflects
the incentive to reduce money holdings when the opportunity cost 𝑖 is high.
Mathematically, the demand curve represents the optimality condition 𝑖= 𝑍′(𝑋),
where 𝑋= 𝑌−(𝑀/𝑃) using the binding transaction constraint.
• The demand curve shifts to the right if 𝑌 increases. In the special case 𝑖= 0, there is
no forgone interest when holding money and the optimal value of 𝑋 is 0. Moreover,
there is no incentive to reduce money holdings until the transaction constraint just
holds. Hence, with a zero nominal interest rate, money demand is 𝑀𝑑 ≥𝑃L(𝑌, 0)=𝑃Y,
which corresponds to a horizontal line at 𝑖= 0. Money demand thus becomes
perfectly interest elastic at 𝑖=0.
• Finally, we note that when money itself pays interest at rate 𝑖𝑚 , all references to 𝑖
above in the money demand function should be replaced by the correct opportunity
cost 𝑖−𝑖𝑚 .

5. Money and Economic Activity:
• In our study of money demand revealed the ways in which it is affected by real GDP
and interest rates. But does money itself matter for real GDP?
• The analysis here will focus on money’s medium of exchange function, which
affects the efficiency with which markets operate. Later in Chapter 8, money’s unit
of account function becomes relevant in the presence of nominal rigidities.
• In this chapter, we look at the implications of economic activity depending on

holding money for some period between selling one thing and buying another.
Money that is a poor store of value over this period acts as a tax on economic
activity, therefore discouraging production and exchange.
• This idea can be illustrated using the labour market as an example. Suppose the
period is a month and workers are paid a wage 𝑊 per hour of labour only at the end
of the month. Wages arrive too late to be spent directly during the same month, and
suppose it is not possible for workers to barter labour for goods, or offer IOUs for
payment when they buy goods.
• Households’ labour supply condition 𝑀𝑅𝑆1,𝐶 = 𝑤 derived in Chapter 1 assumed an

extra hour of labour paid money wage 𝑊 buys 𝑤= 𝑊/𝑃 goods in the same period.
But to work more and spend more during the same month in the monetary economy
described above, a household must either forgo interest by holding on to more cash
at the beginning of the month, swap money and other assets more frequently during
the month at some cost, or pay for goods using credit as an alternative to money. All
of these ways of spending more during the month before actually receiving the wage
at the end of the month entail some cost.
• We derive the amount of goods 𝑤𝑚 that can be purchased in the same month when
a household supplies an additional hour of labour paid money wage 𝑊, holding
constant the household’s future plans for consumption and labour supply.
• The effective real purchasing power of a household’s wages during the month is 𝑤𝑚 ,
which will generally differ from the real cost 𝑤 = 𝑊/𝑃 to firms when wages are paid
at the end of the month.
• Real purchases 𝑤𝑚 cost 𝑃𝑤𝑚 units of money. If the household holds extra money 𝑃𝑤𝑚
instead of bonds during the month to make the purchases then this reduces nominal
wealth by (1+𝑖)𝑃𝑤𝑚 at beginning of next month.

• To leave future spending plans unchanged, this needs to be replenished with the extra
wages 𝑊 received at the end of the month, hence, (1+𝑖)𝑃𝑤𝑚 = 𝑊. Dividing both sides
by 𝑃 implies that 𝑤𝑚 is related to 𝑤 as follows:
𝑤
𝑤𝑚 =
1+𝑖
This equation says that the effective purchasing power of the wages households
receive is reduced by 𝑖 because spending more requires holding more money, which
forgoes interest.
• Alternatively, the household could maintain the same average money holdings
during the month and avoid forgoing interest. However, this requires swapping
between money and other assets more frequently (higher 𝑋) during the month to
cover the additional spending. But this entails transaction costs 𝑞= 𝑍′(𝑋) per unit of
extra spending. Deducting these from the wage received implies 𝑃𝑤𝑚 = 𝑊−𝑞 𝑃𝑤𝑚 . It
follows that 𝑤𝑚 =𝑤/(1+𝑞).
• Finally, credit could be used for the extra purchases made during the month. This
requires paying a fee 𝑞𝑃𝑤𝑚 at the end of month. Deducting that from the wage
implies 𝑃𝑤𝑚 = 𝑊−𝑞 𝑃𝑤𝑚 and hence, 𝑤𝑚 = 𝑤/(1+𝑞). In point 4 earlier on, we saw that
households’ optimal choice of money holdings implies 𝑞= Z’(𝑋)= 𝑖, so this means that
𝑤𝑚 = 𝑤/(1+𝑖) whichever way of paying for current consumption that households
choose.
• Households’ labour supply decision in a monetary economy with the timing

restriction on receiving and spending wages equates the marginal rate of
substitution 𝑀𝑅𝑆1,𝐶 between leisure and current consumption to the effective
current purchasing power of the wage 𝑤𝑚 :
𝑤
𝑀𝑅𝑆1,𝐶 =
1+𝑖
The right-hand side of the equation is lower when the opportunity cost 𝑖 rises,
indicating that money is worse as a store of value. Since working and consuming
more depends on holding money for some time, a positive opportunity cost 𝑖𝑖 works
in a way similar to a proportional tax 𝜏 on wages. A proportional income tax on
wages means the households’ labour supply is determined by 𝑀𝑅𝑆1,𝐶 = (1−𝜏)𝑤.

• This logic points to one way that money matters for real GDP. If money is worse as a
store of value (a high opportunity cost 𝑖) then the implicit tax on economic activity
rises. This leads to a lower labour supply, shifting the 𝑁 𝑠 curve to the left. All else
equal, there is less employment and lower production, which causes a shift of the 𝑌 𝑠
curve to the left. Households are worse off, which reduces consumption demand and
shifts the 𝑌 𝑑 curve to the left as well. Consequently, real GDP 𝑌 is lower. If 𝑌 𝑠 and
𝑌 𝑑 shift by the same amount, then the real interest rate remains unchanged.
The Supply of Money:
• First consider the supply of fiat money by a government or central bank, deferring
discussion of ‘credit money’ created by the banking system until Chapter 7.
• Assume all money is fiat money, for which the government is the monopoly supplier.
The quantity of money in circulation is denoted by 𝑀 𝑠 . For now, we make no
distinction between cash and reserves.
How does the central bank change the money supply? In other words, how does new
money enter circulation or existing money is removed from circulation?
• There are two basic ways this can happen:

1. Open-market operations
2. Transfers.
Since fiat money is intrinsically worthless, the resource costs of creating new money
are negligible and we ignore them in our analysis.
Open Market Operations (OMO):
• An open-market operation is where the central bank buys or sells assets.
• When the central bank buys assets, it pays with newly created money, which
increases the quantity of money in circulation. When the central bank sells assets, it
receives existing money as payment, which is effectively removed from circulation.
(Think about the balance sheet of the Central Bank)
• The central bank can in principle buy any asset in an open market operation or sell
any asset it already holds. It usually transacts with the private sector through its
dealings with commercial banks (rather than buying bonds directly from the
government).
• Traditionally, open-market operations were in markets for short-term government

bonds, or repos (repurchase/resale agreements) of long-term government bonds.

• These assets were chosen because they have low credit risk and a short maturity and
thus protect the central bank from capital losses that would make it harder to
reverse an expansionary open-market operation in the future. But since the 2008
financial crisis, many central banks have also made outright purchases of long-term
bonds or risky assets, for example, quantitative easing (QE) purchases of mortgage-
backed securities in the US.
Transfers:
• A transfer payment is where the central bank distributes money without acquiring
any asset in return, for example, the payment of central-bank profits to a country’s
finance ministry.
• These profits often arise as a normal outcome of the central bank’s operations and
are distributed to the finance ministry as the owner of the central bank.
• However, in principle – putting aside legal rules – a central bank can create new
money and simply distribute it to the finance ministry or others. This could mean
directly paying for government expenditure, or giving the government money to
compensate for lower tax revenues.
• The case of a direct payment of new money to households is known as a ‘helicopter

drop’ of money, though the same economic effect could be achieved by a transfer to
the government to fund a tax cut for households.
Monetary Policy:
• The decisions the central bank makes that affect the supply of money are described
as its monetary policy. For now, we assume monetary policy is an exogenous supply
of money 𝑴𝒔 . This can be represented as a perfectly inelastic money supply curve
(vertical 𝑴𝒔 𝒄𝒖𝒓𝒗𝒆). This supply curve shifts if monetary policy changes.
• We will consider later what monetary policy should be chosen to meet the
objectives of a country’s government.
7. Money and Prices:
• This section combines the demand and supply of money to see how the level of
prices, the inflation rate and the nominal interest rate are determined.

• Here, we suppose that goods prices in terms of money are fully flexible. This means
that the real value of money adjusts to be equal to the real amount of money that
households and firms are willing to hold. In Chapter 8 we consider how an economy
functions differently if there are nominal rigidities, for example ‘sticky prices’.
• With flexible prices, the price level 𝑃 adjusts to ensure the money market clears. The
nominal money supply 𝑀 𝑠 is assumed to be an exogenous amount 𝑀 chosen by the
central bank.
• Rather than consider a completely general monetary policy, we will restrict attention
here to monetary policies where the money supply is expected to grow at some
exogenous rate 𝜇 over time:
𝑴′ = (𝟏 + 𝝁)𝑴
The money demand function is 𝑀𝑑 =𝑃L(Y, 𝑖), and money-market equilibrium 𝑀𝑑 =

𝑀 𝑠 therefore requires 𝑀=𝑃L(𝑌, 𝑖) in the current period and M’ =P’L(𝑌 ′ ,𝑖’) in the
future.
• Nominal and real interest rates are linked by the Fisher equation 𝑖= 𝑟+ 𝜋, where the
inflation rate is defined by 𝜋= (𝑃’−𝑃)/𝑃. The conditions for equilibrium in the money
market now and in the future are therefore 𝑀=𝑃L(𝑌, 𝑟+𝜋) and 𝑀′ =
𝑃′ 𝐿(𝑌 ′ , 𝑟 ′ + 𝛱 ′ ). A graphical representation of the current period equilibrium is
shown in the diagram below where the equilibrium price level 𝑃* is at the
intersection of 𝑀𝑑 and 𝑀 𝑠 .

• By dividing the future money-market equilibrium condition by the current money-

market equilibrium condition we obtain the equation:
𝑀′ 𝑃′ 𝐿(𝑌 ′ , 𝑟 ′ + 𝛱 ′ )
=
𝑀 𝑃𝐿(𝑌, 𝑟 + 𝛱)
We suppose that the types of monetary policies considered here do not affect future
real GDP 𝑌′ differently from how they affect current real GDP 𝑌 (that is, they do not
change the future real GDP growth rate), or the current real interest rate 𝑟 relative
to its future level 𝑟′, or 𝜋 relative to 𝜋′. All else being equal, this means 𝑌= 𝑌′, 𝑟= 𝑟′,
and 𝜋= 𝜋′. Note we have not ruled out that monetary policy affects the levels of 𝑌, 𝑟,
or 𝜋.
• The equation for money-market equilibrium then reduces to 𝑀′/𝑀 =𝑃′/𝑃. With
definitions 𝑀′/𝑀= 1+ 𝜇 and 𝑃′/𝑃 =1+ 𝜋, money-market equilibrium therefore
implies:
𝜋=𝜇
The rate of inflation 𝜋 is equal to the money-supply growth rate 𝜇, which means that
inflation is determined by monetary policy through the choice of 𝜇.
• Intuitively, increases in the money supply shift the 𝑀 𝑠 curve to the right, which imply
that the intersection with 𝑀𝑑 occurs at a higher price level 𝑃 to leave holdings of
real money balances unchanged. And this can be graphically shown as follow:

• Given a real interest rate 𝑟, the Fisher equation implies: 𝑖 = 𝑟+ 𝜇 since 𝜋 = 𝜇.

A higher money-supply growth rate thus raises the nominal interest rate 𝑖 if 𝑟
remains unchanged. This is because a higher nominal interest rate is required to
cancel out the effect of inflation and leave the real return on bonds the same.
Box 6.2: The Instability of Money Demand:
• The analysis of the equilibrium inflation rate might give the impression that only the
money supply growth rate matters, a form of ‘monetarism’. This is because we have
considered only shifts of the money supply curve for a completely stable money
demand curve.
• However, the equilibrium of the money market can also be affected by shifts of the
money demand function and this affects the equilibrium price level for a given
supply of money. If such demand shifts occur then this leads to fluctuations in
inflation even if monetary policy keeps the money supply or money growth constant.
𝑀𝑑
• The money demand curve 𝑃
= 𝐿(𝑌, 𝑖) can shift because of changes in real GDP 𝑌,
which affect the need to use money for transactions. But in addition to this, the function
𝐿(𝑌, 𝑖) itself might not be stable owing to financial innovation.
• New ideas or technologies can change the costs of providing substitutes for money, for
example, credit cards, or change the costs of economising on the average amount of
money held to carry out transactions, for example, ATMs, debit cards and electronic
payments.
• We can represent the effects of these innovations in the model by shifts of the
marginal cost function 𝑍′(𝑋). Since the money demand is determined by the
𝑀𝑑
equation 𝑖=𝑍′(𝑌− ), these changes also shift the money demand function as shown
𝑃
in the diagram below:

• Reduction in the marginal cost of providing substitutes for money or economising on

money holdings increases 𝑋 and reduces money demand, causing the price level to
increase for a given money supply 𝑀 𝑠 .
How serious an issue is the instability of money demand?
• The left panel of the diagram below reports a time series of the quantity of money
𝑀 𝑠 in the USA relative to nominal GDP 𝑃Y. Note that this uses the M1 measure of
the money supply, which is broader than the monetary base and that we study
further in Chapter 7. The measure 𝑀 𝑠 /(𝑃Y) is the inverse of the velocity of money
𝑉=(𝑃Y)/𝑀. In equilibrium, it is also equal to (𝑀𝑑 /𝑃)/𝑌, which is real money demand
relative to real GDP 𝑌. The scaling by GDP is done to control for changes in the
demand for money owing to transactions rising with GDP.
• We see that M1 as a fraction of GDP followed a stable trend prior to the 1980s but
has experienced various shifts in the 1980s, 1990s, and 2000s. The right panel of the
figure is a scatterplot of 𝑀 𝑠 /(𝑃Y) against the nominal interest rate 𝑖, which should
show the downward-sloping real money demand curve scaled by GDP. However, the
plot indicates this relationship has been unstable.

• The exercise is repeated for the broader M2 measure of the US money supply in the
figure below:
• The time series in the left panel suggests the demand for M2 (relative to GDP) has
been more stable than M1. The scatterplot in the right panel comes closer to tracing
out something that resembles a negative relationship between real money demand
(scaled by GDP) and the nominal interest rate 𝑖, though this relationship still appears
to shift at some points in time.
• Overall, the evidence presented here suggests we cannot be confident that

regulating the money-supply growth rate will give tight control over inflation.
8. Money and Public Finance:
• Governments derive a fiscal advantage from being able to issue fiat money that is
demanded by the private sector. Unlike bonds, there is no obligation to ‘repay’ or
redeem fiat money.
• Furthermore, money may pay no interest (𝑖𝑚 = 0), or pay a lower rate of interest than
bonds (𝑖𝑚 < 𝑖). These fiscal gains from issuing money are often referred to as the
‘seigniorage’ revenue of the government. They represent an implicit tax on holders
of money.
• This section looks at how to quantify the fiscal gains that arise from different
monetary policies.

Seigniorage: ‘Printing Money’
• If the money supply is growing at a rate 𝜇 then an amount of new money 𝜇M is

created each time. If it were directly used to finance government expenditure, this
seigniorage revenue would be worth 𝜇M/𝑃 in real terms. Using 𝜋 = 𝜇 that results
from money-market equilibrium, the real amount of seigniorage is 𝜋M/𝑃.
• This is simplest and most direct measure of seigniorage as the fiscal advantage that
comes from ‘printing money’. But this calculation ignores the saving of regular
interest payments on past spending that has been financed in this way rather than
by issuing bonds.
• Moreover, most central banks are not in the business of directly financing
government expenditure. What if – the usual case – the central bank is buying assets
with newly created money?
Seigniorage: Central Bank Investment Income
• Assume money pays no interest and all money created by the central bank has been
used to buy nominal bonds. The central bank holds bonds of monetary value 𝑀 that
matches exactly the existing supply of money 𝑀.
• In this case, the central bank earns interest 𝑖M in each period and, ignoring resource
costs of creating money and any operating costs, these are profits that can be paid
out to the finance ministry.
• Real seigniorage revenues are 𝑖M/𝑃, which represents a flow of revenue received by
the government in each period. Note that this is different from the seigniorage
measure based on the real value of the increase in the money supply.
A General Definition of Seigniorage:
• Even if the central bank does not buy assets, the central-bank investment income
definition of seigniorage still accurately represents the fiscal advantage derived from
steady growth in the money supply.
• The government reduces the cost of financing public expenditure by creating money
rather than issuing interest-bearing bonds. The size of this advantage can be
calculated as the real quantity of money 𝑀/𝑃 in circulation multiplied by the
difference in the returns on bonds and money, which is the nominal interest rate 𝑖
when money does not pay interest.

• Seigniorage then simply represents money being less good as a store of value than
bonds, which is an advantage from the perspective of the issuer of money.
• With 𝑖= 𝑟+ 𝜋, and 𝜋 = 𝜇 in equilibrium with a constant money-supply growth rate 𝜇,

the central-bank profits definition of seigniorage can be broken down into:
𝒊𝑴 𝒓𝑴 𝜫𝑴 𝒓𝑴 𝝁𝑴
= + = +
𝑷 𝑷 𝑷 𝒑 𝒑
This is the saving of real interest payments on bonds otherwise issued plus the
erosion of existing money’s real value due to new money being created.
Limits on Real Seigniorage Revenues:
• As seigniorage arises from money being less good a store of value than other assets,
it is an implicit tax on money. Seigniorage is closely related to the notion of forgone
interest we saw in the analysis of money demand and is essentially identical to the
total amount of forgone interest on money.
• If money becomes a worse store of value because the nominal interest rate 𝑖 is
𝑀𝑑
higher then real money demand = 𝐿(𝑌, 𝑖) falls. Real seigniorage revenues are
𝑃
𝑖M/𝑃=𝑖 L(Y, 𝑖), so there are two conflicting effects of higher 𝑖:
1. The direct effect of money being worse as a store of value.

2. The indirect effect of falling real money demand reducing the real value of
seigniorage.
This means the relationship between real seigniorage revenues and 𝑖 is not
unambiguously positive. Observe that seigniorage is zero if 𝑖=0 and becomes zero
again for high 𝑖 if real money demand 𝐿(𝑌, 𝑖) falls towards zero sufficiently fast as 𝑖
increases. This gives rise to a Laffer curve for real seigniorage revenues as shown in
the figure below, indicating there are limits on the amount of real seigniorage
government can obtain.

The Inflation Tax:
• If there is an unpredictable increase in the inflation rate 𝜋, the nominal interest rate
𝑖 on bonds cannot rise to leave the real return 𝑟 unchanged.
• An inflation surprise thus reduces both the real value of nominal government bonds
as well as existing money. This is reflected in the ex-post real interest rate 𝑟 being
less than the ex-ante real interest rate 𝑟 𝑒 .
• The fiscal advantage derived from such surprise inflation is referred to here as an
‘inflation tax’. A different term is used because the mechanism through which the
inflation tax works is distinct from the source of seigniorage revenue discussed
earlier.
• With the definitions adopted here, seigniorage revenues derive only from money not
bonds and do not depend on inflation being a surprise. In contrast, the inflation tax
depends on inflation that was unexpected when nominal bonds were first issued.
This means that, ex post, the inflation tax does not have any incentive effects on
behaviour – like a lump-sum tax – because it is completely unexpected.
• There is no inflation tax on the real value of nominal bonds when the inflation is
anticipated. In this case, the real return is protected from expected inflation when
the nominal interest rate 𝑖 adjusts in advance.
• Inflation-indexed bonds are also protected against surprise inflation and offer a
guaranteed real return.
The Government Budget Constraint and Ricardian Equivalence:
• In spite of the fiscal advantage that governments can derive from issuing money – a
form of ‘soft default’ on government debt – a government ‘budget constraint’ still
holds once seigniorage and the inflation tax are counted alongside other more
conventional sources of tax revenue.
• Moreover, seigniorage and the inflation tax also show up in households’ budget
constraints alongside explicit taxes because of they bear the losses from forgone
interest and the erosion of the real value of nominal bonds by surprise inflation.
• If the economy has a representative household, it is possible to combine the

household and government budget constraints in the way seen in Chapter 4. The
present value of government expenditure ultimately determines the present value of
tax revenue from all sources, including seigniorage and the inflation tax.

• However, Ricardian equivalence fails because seigniorage is effectively a tax that

distorts incentives.
9. Does Monetary Policy Matter?
Monetary policy should affect nominal prices and inflation but what effects are there, if
any, on real variables such as GDP?
• We can answer this question in the context of a model where the special feature of
money is its role as a medium of exchange. Money matters in different ways, in
particular, through its unit of account function, in the models with nominal rigidities
we will see from Chapter 8.
• We will consider two different changes to monetary policy:

1. A permanent change in the quantity of money in circulation
2. A permanent change in the growth rate of the supply of money in circulation.
A Permanent Change in The Level of The Money Supply:
• Suppose there is an exogenous permanent change in money supply 𝑀 𝑠 = 𝑀. Since

this is exogenous, it is not a reaction to other events or shocks. We assume the
change is unexpected and that no repeat is expected in the future. This means the
level of 𝑀 changes but not its subsequent growth rate 𝜇.
• As the future money supply 𝑀′ changes in the same way as the current money
supply 𝑀, a zero money-supply growth rate 𝜇=0 is expected subsequently because
𝑀′ = 𝑀. However, when the policy change is implemented, there is still an
unexpected change in the money supply 𝑀 relative to its past level.
• Since the change in the money supply is the same in the present as in the future, the
effects on the equilibrium price levels 𝑃 and 𝑃′ are the same. This means that
expected inflation 𝜋=(𝑃′−𝑃)/𝑃 between now and the future period is 𝜋= 𝜇= 0. From
the Fisher equation we therefore conclude that 𝑖= 𝑟+ 𝜋= 𝑟. Although there is no
further inflation expected in the future, there can still be unexpected
inflation/deflation of 𝑃 relative to the past price level.

• Consider the case of an increase in the money supply 𝑀 for illustration. We will see that
the model predicts this increase in 𝑀 has no real effects at all. This result is shown in the
supply-and-demand diagrams for the goods, labour and money markets depicted in the
figure below. But what is the logic for this striking claim?
• First, and most importantly, prices and wages expressed in units of money are fully
flexible here. With no impediments to price adjustment, the same real wage 𝑤 and
real interest rate 𝑟 can continue to ensure supply and demand are brought into
equilibrium in the labour and goods markets. Moreover, there is no money illusion –
everyone’s decisions depend on relative prices and real variables.
• Second, the policy change does not affect perceptions of how good money is as a
store of value going forwards between the current and future time periods. Since 𝑖=
𝑟, there is no change in the nominal interest rate 𝑖 unless 𝑟 changes. The nominal
interest rate 𝑖 is a measure of how bad money is as a store of value relative to other
assets. This means no greater tax on economic activity that depends on holding
money is expected and, hence, there is no reason for the labour and output supply
𝑤
curves to shift through the effect of 𝑖 on the labour-supply condition 𝑀𝑅𝑆𝑙,𝐶 = 1+𝑖.
• Third, while existing holdings of money and nominal government bonds are caught
by a surprise inflation tax that reduces the real value of households’ financial assets,
the inflation tax also allows the government to reduce other taxes and still pay for
the same level of public expenditure. These tax cuts offset the reduction in the value
of financial assets and there is no wealth effect overall on households – Ricardian
equivalence holds after accounting for the government budget constraint.
• Thus, we conclude there are no reasons for any shifts of the 𝑁 𝑑 , 𝑁 𝑠 , 𝑌 𝑑 , or 𝑌 𝑠

curves. Therefore, the equilibrium values of 𝑤*, 𝑟*, 𝑁*, and 𝑌* are unaffected.

• A permanent change in the money supply has no real effects. No change in 𝑌 or 𝑖

means there is no shift of the money demand curve 𝑀𝑑 . The rightward shift of the
money supply curve 𝑀 𝑠 thus leads 𝑃 to rise in proportion to 𝑀. Given these
predictions, money is said to be ‘neutral’.
A Permanent Change in The Growth Rate of The Money Supply:
• Alternatively, suppose there is a permanent adjustment of the growth rate of the

money supply 𝜇. This money-supply growth rate is defined by 𝜇=(𝑀′−𝑀)/𝑀, hence,
the future money supply is given by 𝑀′=(1+𝜇)𝑀. The change in 𝜇 is exogenous,
unexpected and no further adjustments of 𝜇 are expected. Note that there is no
change in the initial money supply 𝑀 here.
• Since the policy change affects expectations of the future money supply, inflation
expectations 𝜋=(𝑃’−𝑃)/𝑃 adjust. The effect on the equilibrium current and future
price levels 𝑃 and 𝑃’ is such that 𝜋= 𝜇, so any changes in money-supply growth are
reflected one-for-one in changes in expected inflation.
• Consider the case of faster money growth for illustration. We will see that increasing
the money growth rate does have real effects. These are depicted in the supply-and-
demand diagrams below:
• The logic for the real effects is that higher money growth 𝜇 raises expectations of
future inflation 𝜋. The Fisher equation 𝑖= 𝑟+ 𝜋 then implies the nominal interest rate
𝑖 is higher for each value of the real interest rate 𝑟. From the labour-supply equation
𝑤
𝑀𝑅𝑆𝑙,𝐶 = 1+𝑖 , higher 𝑖 has a negative effect on labour supply.
• Intuitively, because money is a worse store of value, the implicit tax on economic
activity rises, which causes the supply of labour to decline. Consequently, the output
supply curve 𝑌 𝑠 shifts to the left and, as this change is permanent, 𝐶 𝑑 falls in line
with income, leading to a leftward shift of 𝑌 𝑑 of same size as the shift of 𝑌 𝑠 .

• If a permanent change in the money supply growth were to have no effects on any
real variables then we would say that money is ‘superneutral’.
• The term ‘neutrality’ used earlier refers to there being no real effects of a permanent
change to the level of 𝑀. We see in the diagrams above that the model predicts
money is not superneutral.
• Permanently faster growth of the money supply reduces real GDP and employment
because money is less good as a store of value. This inflationary policy has a negative
real effect on the economy’s supply side.
• In the money market, there is no initial change in 𝑀, so no shift of the money supply
curve 𝑀 𝑠 to begin with. The money demand curve 𝑀𝑑 pivots to the left as there are
fewer transactions due to lower GDP 𝑌 and more efforts to economise on holding
money or make use of money substitutes (higher 𝑋) because of higher 𝑖. This leads
real money balances 𝑀/𝑃 to fall as 𝑀𝑑 /𝑃 is lower, which causes an immediate jump
up in the level of prices 𝑃.
Box 6.3: Money Supply Increases That The Central Bank Announces Are Temporary
• We have looked at the consequences for prices, inflation and real economic
variables of permanent changes to the quantity of money or the growth rate of the
money supply. But central banks might change the money supply temporarily in
some circumstances.
• For example, quantitative easing (QE) might increase the money supply but it is the
central bank’s stated intention to unwind the policy in the future. QE expansions of
money supply have turned out to be persistent in most countries, although this may
not have been expected when they were first begun.
• There are cases where QE has been temporary, such as the Bank of Japan QE policy
from 2001, which was largely reversed in 2006. Another example of a temporary
change is the ‘de-monetization’ experiment in India in 2016, where there was a
temporary decline of the money supply.
• To see what difference it makes when a money-supply change is expected to be

temporary, suppose 𝑀 𝑠 = 𝑀 is expected to change for only one time period.
Throughout, we hold the expected future money supply 𝑀′ constant. Consequently, the
equilibrium future price level 𝑃′ does not change in this example.

• The Fisher equation 𝑖= 𝑟+ 𝜋 and the definition of expected inflation 𝜋=(𝑃′−𝑃)/𝑃

imply that the nominal interest rate 𝑖 is:
𝑃′ − 𝑃 𝑃′
𝑖=𝑟+ =𝑟+ −1
𝑃 𝑃
• Money-market equilibrium is the equation 𝑀= 𝑀 𝑠 = 𝑀𝑑 = 𝑃L(𝑌, 𝑖), and, hence:

𝑃′
𝑀 = 𝑃𝐿 (𝑌, 𝑟 + − 1)
𝑃
• The key point to note is that a higher price level 𝑃 lowers the nominal interest rate 𝑖
here, so the effect of 𝑃 on money demand is magnified. We ignore here any effect of
𝑖 on 𝑌 (but accounting for that would further boost the impact of 𝑃 on 𝑀𝑑 ).
• In what follows, we assume that nominal interest rate 𝑖 remains positive throughout.
The diagram below depicts the relationship between 𝑀𝑑 and 𝑃 in this case for given
𝑌 and 𝑟 and the relationship in the case where changes in the money supply are
permanent, in which case money demand 𝑀𝑑 = 𝑃L(𝑌, 𝑟) is proportional to 𝑃 and is
thus represented by a straight line in the diagram.
• Following temporary increase in 𝑀, the money supply curve 𝑀 𝑠 shifts to the right as
usual. If the policy is expected to be reversed in future, any rise in the price level is
also expected to be reversed. Therefore, a higher price level 𝑃 would create
expectations of future deflation, reducing the nominal interest rate 𝑖 and boosting
money demand.

• In the diagram, 𝑀𝑑 is thus less steep than the usual 𝑃L(Y, 𝑟) money-demand
function. It follows that the price level rises by proportionately less than 𝑀 does, in
contrast to the case of a permanent change where 𝑃 rises in proportion to 𝑀.
• This different prediction compared to the case of a permanent change in 𝑀 is likely

to be quantitatively significant. If there were a 25 per cent higher money supply
temporarily and 𝑃 went up by 25 per cent initially then this would require 25 per
cent expected deflation subsequently. But that cannot be an equilibrium because 𝑖 ≥
0 implies deflation cannot exceed the much lower equilibrium value of the real
interest rate 𝑟. The price level 𝑃 must therefore rise by far less than 25 per cent.
10. Optimal Monetary Policy and The Costs of Inflation
Focusing on money’s role as a medium of exchange, what should the central bank do if it
desires to make the economy run smoothly?
Economic Efficiency:
• The marginal value of households’ time in terms of goods is the marginal rate of
substitution 𝑀𝑅𝑆𝑙,𝐶 between leisure and consumption. The economy’s ability to
transform households’ time into goods at margin, the marginal rate of
transformation 𝑀𝑅𝑇𝑙,𝐶 , is given by the marginal product of labour 𝑀𝑃𝑁. Ignoring
transaction costs, efficiency therefore requires that 𝑀P𝑁= 𝑀𝑅𝑆𝑙,𝐶 .
• In respect of transaction costs, we noted that there are costs of using substitutes for
money, or using time and effort to economise on holding money. Those resource
costs are represented by the function 𝑍(𝑋) and they constitute a social cost of
carrying out transactions.
• On the other hand, when holding money, the cost of forgone interest is not a social
cost because the government gains an equal amount of seigniorage revenues.
Forgone interest is simply a transfer from holders of money to issuers of money.
Monetary Policy, Efficiency, and The Friedman Rule
• Consider how the choice of monetary policy affects the efficiency of the economy’s
equilibrium. The demand for labour 𝑁 𝑑 is given by 𝑀𝑃𝑁 = 𝑤 and labour supply 𝑁 𝑠 is
determined by 𝑀𝑅𝑆𝑙,𝐶 = 𝑤/(1+𝑖). This equation for 𝑁 𝑠 comes from wages being paid
as money that must be held for some period before it can be spent. When the labour
market is in equilibrium (𝑁 𝑑 = 𝑁 𝑠 ), it follows that 𝑀P𝑁= w= (1+ i)𝑀𝑅𝑆𝑙,𝐶 .

• A positive value of the nominal interest rate 𝑖 implies 𝑀P𝑁 > 𝑀𝑅𝑆𝑙,𝐶 , which
corresponds to employment and output being inefficiently low relative to the
optimal outcome with 𝑀P𝑁 = 𝑀𝑅𝑆𝑙,𝐶 .
• It is also possible to consider efficiency in respect of transaction costs. There is a

demand 𝑋 𝑑 (𝑖) for substitutes for money that depends on the nominal interest rate 𝑖,
which is the opportunity cost of holding money.
• The demand for 𝑋 is increasing in the nominal interest rate 𝑖. The social cost of
transactions is then 𝑍[𝑋 𝑑 (𝑖)] where forgone interest is not included directly because
it is not a social cost. A positive nominal interest rate 𝑖 implies 𝑋 𝑑 (𝑖) >0 and
𝑍[𝑋 𝑑 (𝑖)] >0, which means that transaction costs are inefficiently high.
• Now suppose monetary policy is conducted so that 𝑖= 0. This means there is no

forgone interest when holding money. Consequently, there is no incentive to find
substitutes for money, or incur costs in economising on holding money, so
transaction costs are reduced to zero, i.e. 𝑍(𝑋)=0.
• Furthermore, there is no implicit tax on economic activity (work) that depends on

holding money because money is as good a store of value as other assets. This
means that 𝑀P𝑁 = 𝑀𝑅𝑆𝑙,𝐶 , so employment and output are at their efficient levels. In
conclusion, the monetary policy 𝑖= 0 ensures the economy’s equilibrium is efficient.
This policy of keeping the nominal interest rate at zero is known as the ‘Friedman
rule’.
The Optimal Rate of Inflation and The Friedman Rule
• To implement the Friedman rule, the central bank needs to set the money supply
growth rate 𝜇 so that 𝑖= 0 is achieved. The analysis in chapter 6 point 7 shows that
inflation and money supply growth are equal, that is, 𝜋= 𝜇.
• By using the Fisher equation 𝑖= 𝑟+ 𝜋, it follows that 𝜇= −𝑟 is required to implement

the Friedman rule. A positive equilibrium real interest rate 𝑟 (which is independent
of monetary policy here) implies the required money growth rate 𝜇 is negative.
Therefore, the central bank must reduce the nominal money supply over time to
implement the Friedman rule.

• Since 𝜋 = 𝜇= −𝑟 <0, the Friedman rule requires deflation. In other words, the inflation
rate needed for economic efficiency is negative. Higher rates of inflation 𝜋, including
zero or positive rates, imply that 𝑖 is higher, which means the economy’s equilibrium
is further away from what is efficient. The Friedman rule thus provides a way to
understand the costs of inflation but also suggests that deflation is a good thing.
The Fiscal Implications of Following The Friedman Rule
• Implementing the Friedman rule has fiscal implications because no seigniorage

revenue is received when 𝑖= 0. Governments therefore need to find alternative
sources of tax revenue to continue to pursue their plans for public expenditure.
• Another way to think of this is that the negative inflation rate required for the
Friedman rule implies there is a positive real return on non-interest-bearing money
coming from its purchasing power growing over time. This makes it as good a store
of value as bonds with real return 𝑟.
• Since money offers the same return as bonds, money is effectively being treated by
the government as a debt liability that must be repaid. The deflation that supports
the Friedman rule is achieved by buying back money to reduce its supply, which
works like repaying a debt. Money can only be repurchased by the central bank
selling its assets or using tax revenue transferred from the government. Hence, other
taxes must rise if government spending is to remain unchanged.
• Note that if other taxes create distortions, for example, income tax, then it may not
be optimal to follow the Friedman rule because this would replace one distortion
(positive 𝑖) with another distortion (a higher income tax rate). We have implicitly
been assuming that the lost seigniorage revenue could be replaced by lump-sum
taxes.
Box 6.4: Hyperinflation
• Hyperinflation refers to an extremely high rate of inflation. The exact definition is

arbitrary, but a threshold of ≥50 per cent inflation per month is conventional. Such
high rates of inflation occur with extremely fast money growth rates, causing
nominal interest rates to be very high as well.
• Our analysis of the non-superneutrality of money in Chapter 6 point 9 provides a

reason why such high rates of inflation have a damaging effect on the real economy.
As explained earlier on, inflation works as a tax on economic activity that depends on
using money. This effect was incorporated into our model through the equation
𝑀𝑅𝑆𝑙,𝐶 = 𝑤/(1+𝑖) for labour supply and the Fisher equation 𝑖= 𝑟+ 𝜋.

• These negative supply-side effects of inflation give rise to inefficiencies and

constitute a social cost of inflation.
• While such effects are theoretically present even at single-digit rates of inflation,
they are likely to be very small in that case. The implicit tax rate on economic activity
coming from inflation is approximately equal to the nominal interest rate 𝑖 and, to be
precise, this is the nominal interest rate over the period of time people cannot avoid
holding on to cash they receive, not the annual nominal interest rate.
• Taking that period to be no more than a month, single-digit annual inflation rates
would not generate an implicit tax rate of more than 1 per cent, resulting in a
generally small social cost. However, in a hyperinflation with monthly inflation rates
above 50 per cent, it is easy to see that the implicit tax rate can be very high, even if
people try to shorten the period over which they hold on to cash they receive.
Hence, the social cost of inflation through this mechanism is far larger in a
hyperinflation.
If hyperinflation has such serious negative effects on economy, why do governments

choose very fast money supply growth?
• We have seen that governments derive a fiscal advantage from money creation
(‘seigniorage’). If there is a sudden, large change in public expenditure needs, for
example, a war, seigniorage provides a quick source of extra revenue for
governments without having to adjust explicit tax rates. However, as inflation and
the nominal interest rate rise, the demand for real money balances declines. This
implies real seigniorage revenues are limited, as shown in the seigniorage Laffer
curve.
• If the government’s fiscal needs in an emergency exceed the top of the seigniorage
Laffer curve then attempts to raise further seigniorage revenues may lead to
explosive rates of money growth and accelerating inflation as real seigniorage
revenues fall short of the government’s needs. Thus, a hyperinflation can easily
spiral out of control with severe consequences for the economy unless the
government can reduce its expenditure or find alternative sources of tax revenue.

Box 6.5: Cash and Tax Evasion
• An important feature of money in the form of physical cash is its anonymity. Unlike
most other assets, there is no register of ownership or necessarily any record of
transactions in cash. Thus, cash is sometimes described as a ‘bearer bond’, meaning
the owner is deemed to be whoever has physical possession of the asset. The
anonymity of cash makes it ideal to evade taxes, including taxes on purchases,
income, or wealth. Part of the demand for cash therefore comes from its tax-evasion
advantages relative to other assets.
• Our analysis of the demand for money earlier on was based on a comparison of
𝑀𝑑
benefits and costs. The marginal cost of holding higher real money balances is 𝑖,
𝑃
𝑀𝑑
the forgone interest on bonds. The marginal benefit of higher was 𝑞 =𝑍’(𝑋)
𝑃
previously. Now, a marginal value 𝑒 of the tax-evasion advantage of money is added
𝑀𝑑
to this and the overall marginal benefit of higher is 𝑞+𝑒.
𝑃
• The demand for cash is found where the marginal benefit equals the marginal cost, i.e.
where 𝑖 = 𝑞+ 𝑒=𝑍’(𝑋)+𝑒. This is equivalent to the equation 𝑍’(𝑋)= 𝑖− 𝑒, so the
𝑀𝑑
nominal interest rate 𝑖 in the usual money demand function = 𝐿(𝑌, 𝑖) is replaced by
𝑃
𝑖− 𝑒 when cash has a tax evasion advantage. The new money demand function
𝑀𝑑
=𝐿(𝑌, 𝑖−𝑒) is higher at each interest rate 𝑖, so there is a rightward shift of 𝑀𝑑 plotted
𝑃
against 𝑖 as shown below:
• While individuals might gain from the use of cash for tax evasion, the marginal
private benefit 𝑒 is not a social benefit of using money. When tax evasion occurs,
other taxes need to be higher to pay for public expenditure.

• Furthermore, cash also facilitates criminal activity, imposing negative externalities on

others. These considerations mean it is not desirable for monetary policy to
maximise individuals’ use of cash in the way that it would if the Friedman rule were
followed.
• Since the only social benefit of money is in reducing transaction costs 𝑞 = 𝑍′(𝑋),
optimal monetary policy should aim to push 𝑞 to zero, ignoring both the private cost
of money in terms of forgone interest 𝑖 (not a social cost) and the private benefit 𝑒
when money is used for tax evasion (not a social benefit). With 𝑖 = 𝑞+ 𝑒 in
equilibrium, this suggests monetary policy should aim for 𝑖 = 𝑒 >0, a positive nominal
interest rate 𝑖 and a higher rate of inflation 𝜋 (or less deflation) than what is implied
by the Friedman rule.
• By following this policy, the implicit tax on money through 𝑖 >0 cancels out the tax
evasion advantage. Money being a worse store of value makes tax evasion harder
and provides a way to tax illegal activities.
• Technological advances have made transactions by debit card and bank transfers
much cheaper and easier, even for small payments. As the payments system now
enables bank deposits to be used for almost all transactions, it has been suggested
that physical cash can and should be abolished.
• Since bank deposits lack the anonymity of cash, eliminating cash would help to
reduce tax evasion and criminal activity. But some argue that cash might occasionally
offer greater convenience and, more importantly, the anonymity offered by cash
could be a desirable feature in preserving individuals’ privacy and civil liberties.
11. Conducting Monetary Policy By Setting Interest Rates
• Monetary policy has so far been described as an exogenous level, or growth rate, of
the money supply. The instrument of monetary policy was the quantity of money
and the target for monetary policy was a monetary target.
• However, the ultimate objective of monetary policy is usually not the money supply
itself but control of interest rates, inflation, or other macroeconomic variables.
Moreover, central banks are often described as setting interest rates rather than
setting the money supply.

• And we know from Box 6.2 that a fixed money supply target does not achieve price
stability if money demand is unstable, so a monetary target might not be desirable
with these other objectives in mind.
• This section explores how monetary policy works if the central bank uses an
interest rate as its operating target.
• Rather than setting the money supply 𝑀 at some target level, the central bank now has
a target for the nominal interest rate 𝑖. However, market interest rates are not directly
controlled by the central bank, so it needs to vary some policy instrument under its
control to achieve its interest rate target.
• We assume this means the use of open-market operations. The central bank must be
willing to increase or decrease 𝑀 so that the money market is in equilibrium at its target
for the nominal interest rate 𝑖. This makes the supply of money 𝑀 become an
endogenous variable determined by the equation:
𝑴
= 𝑳(𝒀, 𝒊)
𝑷
What are the implications of conducting monetary policy in this way?
• We will focus here on the determination of prices and inflation, assuming that
monetary policy does not affect real GDP 𝑌 or the real interest rate 𝑟.
• The Fisher equation is 𝑖 = 𝑟+𝜋′𝑒 , where 𝜋′𝑒 = (𝑃′𝑒 − 𝑃)/𝑃 explicitly denotes expected
inflation between the current and future time periods, which might not be the same
as the realised inflation rate. In equilibrium, expected inflation must be 𝜋′𝑒 = 𝑖− 𝑟.
• Given an exogenous target for 𝑖𝑖 and an equilibrium for 𝑟 that is independent of

monetary policy, this equation determines a unique equilibrium for expected
inflation 𝜋′𝑒 . A low nominal rate 𝑖 is associated with low expected inflation in
equilibrium.
What about the absolute level of prices 𝑃𝑃 and the inflation rate between the past and
current period?
• With an endogenous money supply 𝑀, there are many possible price levels 𝑃
𝑴
consistent with = 𝑳(𝒀, 𝒊). This is because 𝑀 adjusts to ensure this equation holds
𝑷
at the central bank’s target level of 𝑖. It follows that setting a target for interest rates
does not by itself give the economy a ‘nominal anchor’ – the level of prices 𝑃 in
terms of money is indeterminate.

• In practice, what this means is that a fixed 𝑖 policy does not rule out unexpected
fluctuations in inflation, even though expected inflation is determinate.
• A traditional monetary target does provide a nominal anchor in the sense of there
being a unique equilibrium for the levels of prices and inflation. Given a demand for
real money balances, an exogenous nominal quantity of money means there is only
one possible level of prices in equilibrium.
• But we have seen that a fixed money supply not desirable if real money demand
fluctuates. Moving away from targeting the money supply is desirable but simply
setting a fixed target for the nominal interest rate has pitfalls. The way forward is to
consider an alternative approach to monetary policy, the use of an interest-rate
feedback rule, the most famous example of which being the Taylor rule.
12. Taylor Rules and The Taylor Principle
• The Taylor rule is an example of what is known as an interest-rate feedback rule.

Instead of an exogenous money supply or interest rate target, a feedback rule has
the central bank actively adjust the interest rate it sets to meet an objective.
• Assume here that an inflation target 𝜋∗ is the central bank’s only objective.
• A simple version of the Taylor rule is given in the following equation:
𝑖= 𝑟̂ + 𝜋*+ 𝜙(𝜋− 𝜋*)
This describes how the central bank sets the nominal interest rate 𝑖.
• According to the Taylor rule, the level of 𝑖 should depend on the actual rate of
inflation 𝜋 that occurs between the past and current period. The coefficient 𝜙
indicates how strongly the central bank reacts to inflation 𝜋 missing its target 𝜋*.
• If 𝜋 is one percentage point higher then 𝑖 is raised by 𝜙 percentage points. The

special case of 𝜙=0 represents an exogenous interest rate target that is not adjusted
to the actual inflation rate.
• Finally, the term 𝑟̂ denotes the central bank’s estimate of the equilibrium real
interest rate 𝑟.
• It is argued that a sufficiently strong response to inflation, as measured by the

parameter 𝜙, ensures the equilibrium inflation rate 𝜋 is determinate (and will be on
target 𝜋* if the estimate of 𝑟 is correct).

• To be precise, a sufficiently strong response means that 𝜙 >1, so the nominal

interest rate reacts more than one-for-one to inflation. This is known as the ‘Taylor
principle’.
• To see the argument, we combine the Fisher equation 𝑖 = 𝑟+𝛱′𝑒 written explicitly in
terms of expected inflation π′𝑒 =(𝑃′𝑒 −𝑃)/𝑃 between the current and future periods
and the Taylor rule 𝑖 = 𝑟̂+ 𝜋*+ 𝜙(𝜋−𝜋*).
• By eliminating 𝑖 from these equations:
𝑟 + π′𝑒 = 𝑟̂+ 𝜋* + 𝜙(𝜋−𝜋*)= 𝑟̂+ 𝜋+ (𝜙−1)(𝜋−𝜋*)
• This can be rearranged to write an equation for the expected change in the inflation
rate over time:
π′𝑒 − 𝜋 =(𝜙−1)(𝜋− 𝜋*)−(𝑟− 𝑟̂)
The Taylor principle 𝜙 >1 implies the coefficient on 𝜋−𝜋*, the extent to which
inflation 𝜋 misses its target 𝜋*, is positive. Consequently, higher inflation now would
mean that inflation is expected to rise faster in the future and lower inflation now
would mean that subsequent inflation is expected to fall faster. It follows that there
is only one value of inflation 𝜋 where subsequent inflation is not expected to keep
rising or keep falling (although this argument ignores the lower bound on 𝑖 as
explained later in Box 6.6).
• If π′𝑒 = 𝜋, so inflation is neither expected to rise or fall further in future, then:
𝒓 − 𝒓̂
𝝅 = 𝝅∗ +
𝝓−𝟏
This is the unique stable equilibrium for inflation when 𝜙 >1. If the Taylor principle
𝜙>1 is not satisfied then there are many stable paths of inflation over time that are
equally consistent with the interest-rate rule and equilibrium in the economy.
• We see from the equation that inflation is on target if the central bank’s estimate 𝑟̂
of the equilibrium real interest rate 𝑟 is correct. Underestimating this (𝑟̂ < 𝑟) leads to
inflation above the target (𝜋 > 𝜋∗).

• Our analysis of the Taylor rule suggests that central banks wanting to meet an
inflation target have two key tasks:
1. to make a strong reaction to any deviation of inflation from its target so that the
Taylor principle (𝜙 >1) is satisfied.
2. to obtain an accurate estimate of market-clearing real interest rate 𝑟.
13. The Liquidity Trap and The Zero Lower Bound
• There are two important limitations on the power of monetary policy which are the
zero lower bound and the liquidity trap.
The Zero Lower Bound:
• The zero lower bound is the claim that the nominal interest rate 𝑖 on bonds cannot
be negative, so the equilibrium of the economy always features 𝑖 ≥0. The logic for
this comes from the money demand trade-off analysed in the earlier part of the
chapter.
• Holding more money has the cost of forgoing interest when 𝑖 is positive. On the
other hand, money is useful for making payments and holding more of it avoids the
costs of using substitutes for money, or of managing to carry out transactions while
holding only a small amount of money on average. The marginal benefit of holding
an extra unit of real money balances is represented by the cost reduction 𝑍′(𝑋).
• The marginal benefit 𝑍′(𝑋) cannot be negative but can be zero if 𝑋 has already
reached 0. If the nominal interest rate 𝑖 on bonds were negative, this would mean
that cash is a better store of value than bonds, while also having a non-negative
benefit relative to bonds in saving transaction costs. Hence, 𝑖 <0 would imply money
is always preferred to bonds, which is not possible in equilibrium because then there
would be no demand for bonds.
The Liquidity Trap:
• The liquidity trap is the idea that money and bonds become perfect substitutes at
the margin once the lower bound on nominal interest rates is reached. It implies
increases in the quantity of money might be passively absorbed with no impact on
the economy.

• At the zero lower bound 𝑖=0, no interest is forgone by holding more money.
𝑀𝑑
Furthermore, once holdings of real money balances reach 𝑌 (the amount needed
𝑃
to make all payments using money without incurring any transaction costs), the
marginal benefit of lowering transaction costs 𝑍(𝑋) by holding more money is zero.
• With a zero marginal cost and a zero marginal benefit, households and firms are
𝑀𝑑 𝑀𝑑
indifferent about whether they hold higher or not. But can be larger than 𝑌 at
𝑃 𝑃
𝑖=0 because money has become as good a store of value as bonds. Consequently,
money demand 𝑀𝑑 is perfectly interest elastic at the interest-rate lower bound 𝑖=0.
• Using the same framework as in Box 6.3, we see that a temporary expansion of 𝑀 𝑠
has no effect on either the nominal interest rate 𝑖 or the price level 𝑃 once the zero
lower bound is reached. In the left panel of the figure below, the demand for real
money balances is perfectly interest elastic (horizonal) at 𝑖=0. The money market is
𝑀𝑠
still in equilibrium at 𝑖=0 after a shift of to the right with higher 𝑀 𝑠 (assuming no
𝑃
change in 𝑃 for now). This additional money is willingly held with no change in the
interest rate. To confirm that the price level 𝑃 does not change either, the right
𝑃′
panel of the figure shows the money demand function 𝑀𝑑 =𝑃L(𝑌, 𝑟+( 𝑃 )−1), which
𝑀𝑑
combines the Fisher equation 𝑖= 𝑟+ 𝜋= 𝑟+(𝑃′−𝑃)/𝑃 with = 𝐿(𝑌, 𝑖). Taking the
𝑃
future price level 𝑃′ as given (because the change in 𝑀 𝑠 is only temporary), money
demand is perfectly elastic with respect to the price level 𝑃 once 𝑖 =0 is reached. The
horizontal demand curve implies that the rightward of the supply curve 𝑀 𝑠 does not
change the equilibrium price level.

• It is important to note this argument does not apply to permanent expansions of the
money supply 𝑀 𝑠 where the central bank can convince people that it will never
reverse the policy change. This should affect expectations of future prices 𝑃′, which
𝑃′
would shift 𝑀𝑑 =𝑃L[𝑌, 𝑟+( 𝑃 )−1], resulting in a change of 𝑃 or 𝑖 or both.
14. Negative Nominal Interest Rates
• The models of money we have seen in this chapter predict that bonds cannot have a
negative nominal interest rate in equilibrium. But instances of negative nominal
interest rates have been observed, for example, in some eurozone countries from
around 2016. Does this mean we missing something important about money from
our model?
Is There A Lower Bound On Nominal Interest Rates?
• The logic of our earlier argument for why 𝑖 <0 should be impossible is that a negative
nominal return on bonds would lead wealth held in the form of bonds to be switched
into cash to receive the guaranteed zero nominal return (𝑖𝑚 = 0) on cash. Note that
only cash by its nature necessarily offers a zero nominal return; other forms of
money in electronic accounts, such as reserves held at the central bank, could in
principle have 𝑖𝑚 <0. However, as long as physical cash exists as a form of money, its
zero nominal return is always available to investors.
• The key point missing here is that switching large amounts of wealth into physical
cash would entail security costs of keeping it safe. Unlike bonds and most assets,
there no register of ownership of physical cash – this is why cash gives anonymity –
and so holders of cash must consider the cost of keeping this physical object secure.
• Assume that holding cash entails a security or storage cost that is a proportion ℎ of
the amount of cash held. This is a resource cost of holding cash, in addition to
forgone interest 𝑖 (if any).
• Consider again the money demand trade-off. Raising 𝑋 to reduce the amount of cash
held and increase bond holdings leads to a gain of 𝑖+ℎ per unit increase in 𝑋, saving
security costs plus any forgone interest. Raising 𝑋 by one unit has a marginal cost
𝑞=𝑍’(𝑋), so the optimal 𝑋 is found where 𝑖+ℎ= 𝑞 =𝑍′(𝑋), not where 𝑖 = 𝑍′(𝑋) as
before.
• Since 𝑖+ℎ replaces 𝑖 but the equation is otherwise the same, it follows that the usual
𝑀𝑑 𝑀𝑑
money demand function = 𝐿(𝑌, 𝑖) becomes = 𝐿(𝑌, 𝑖+ℎ). As money demand is
𝑃 𝑃
decreasing in 𝑖, adding the positive value of ℎ shifts 𝑀𝑑 downwards.

• Geometrically, this is a parallel downward shift by an amount ℎ of the real money

demand curve plotted against 𝑖, as shown in the diagram below:
• The diagram shows it is now possible to have an equilibrium with a negative nominal
interest rate 𝑖 <0. Bonds with a negative nominal return are willingly held because
the security costs of switching to physical cash holdings are too large. Note that
bonds themselves are not subject to the same security problems of cash because
there is a register of ownership.
• Although we can now understand why nominal interest rates can be negative, it
turns out that there is still a lower bound on 𝑖, only now a negative one. As can be
seen from the diagram, it is not possible to have 𝑖 be less than −ℎ, that is, 𝑖 cannot be
below the negative of the security cost as percentage of the value of cash stored.
The lower bound is therefore 𝑖 ≥ −ℎ. In practice, ℎ should not be much more than 1
per cent for large amounts of physical cash, which would suggest a lower bound on 𝑖
of approximately −1 per cent.
Costs Of Negative Interest Rates
• Although our analysis has explained why a negative nominal interest rate 𝑖 is
possible, it does not explain why one would be desirable – and indeed the logic
suggests that negative nominal interest rates have social costs.
• Consider what is optimal monetary policy here. There are resource costs of both
holding more cash (ℎ) and using substitutes for cash or economising on cash holdings
(𝑍′(𝑋)). All means of payment therefore have a social cost.

𝑀𝑑
• The marginal net social cost of lower 𝑋 (or equivalently, higher ) is ℎ−𝑍’(𝑋), so
𝑃
economic efficiency requires ℎ= 𝑍′(𝑋). Since 𝑖+ℎ= 𝑍′(𝑋) in equilibrium, the Friedman
rule 𝑖 =0 therefore achieves efficiency.
• Note that it is now efficient to have 𝑋 >0, so cash is not used for all transactions.
Having a negative nominal interest rate 𝑖 <0 has social costs because it leads to over-
use of cash, which wastes resources on security and storage costs, just as the earlier
argument for the Friedman rule pointed to the waste of resources in finding
substitutes for cash when 𝑖 >0.
Lowering The Lower Bound
The analysis suggests there is a negative lower bound on the nominal interest rate but one
not too far below zero in practice. What if governments want to lower interest rates
further below zero?
• It is possible to envisage changes to the monetary system that would permit this. For
example, cash might have an ‘expiry date’, with an amount deducted if people need
to convert old, expired cash into new cash (what is sometimes known as a ‘Gesell
tax’). If 𝜏 is an explicit tax on holding cash, money demand 𝑀𝑑 is determined by the
equation 𝑖+𝜏= 𝑞=𝑍′(𝑋).
• Analogous to having a security cost ℎ, this implies the lower bound on 𝑖 is now −𝜏,
which can be lowered by raising 𝜏. Similar outcomes can be achieved by limits on
convertibility between physical cash and other forms of money such as reserves and
bank deposits. Finally, abolishing physical cash and moving to a system of purely
electronic money would remove the lower bound on nominal interest rates entirely.
• None of this analysis explains why governments should do such things and points to
inefficiencies in making it harder or more costly to make use of money for
transactions. In Chapter 9, we see that there might be circumstances where
macroeconomic stabilisation policies work more effectively if the lower bound on
nominal interest rates can be circumvented.
Please read up Box 6.6 in the subject guide on your own.

Macroeconomics EC2065 CHAPTER 6 - MONEY AND MONETARY POLICY

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EC2065 MACROECONOMICS

CHAPTER 6: MONEY AND MONETARY POLICY

Williamson, Chapters 12 and 18.

1. Why Does Money Matter?

PREPARED BY CHEN AIDI 1

• Money functions as a medium of exchange because money is accepted as payment

• Money functions as a unit of account as it is convenient to quote prices in terms of

PREPARED BY CHEN AIDI 2

• It is convenient to express all prices as amounts of money. Similarly, in contracts

Different Objects That Serve As Money:

2. A Search Theory Perspective On Money:

PREPARED BY CHEN AIDI 3

• An alternative approach is known as ‘search’ theory. In a search model, all trade is

A Simple Search Model of Money:

• A specific example of the three individuals is given in the figure below:

PREPARED BY CHEN AIDI 4

• For a good to serve as a commodity money, it should be:

PREPARED BY CHEN AIDI 5

• The disadvantage of a system of commodity money is that the system ties up

• An alternative to a system of commodity money is to use credit money.

PREPARED BY CHEN AIDI 6

Money And Credit:

PREPARED BY CHEN AIDI 7

• A system of credit money has some important advantages:

• The disadvantages of credit money are:

PREPARED BY CHEN AIDI 8

• However, such a system of credit-based payments has costs for financial

• Another form of money in widespread use is fiat money. This is defined as

• In accounting terms, fiat money is recorded as a liability of the government or

PREPARED BY CHEN AIDI 9

PREPARED BY CHEN AIDI 10

• However, in practice, the concern about self-fulfilling losses of confidence in fiat

Box 6.1: Cryptocurrencies:

• Recent years have seen a rise to prominence of cryptocurrencies, most famously

• Nonetheless, cryptocurrencies share some features of fiat money. They have no

• Proponents of cryptocurrencies have put forward several advantages namely:

1. The blockchain technology they build on makes transactions very secure.

2. Because the supply of a particular cryptocurrency is limited by design, it is argued

PREPARED BY CHEN AIDI 11

• Critics of cryptocurrencies argue there are serious disadvantages namely:

2. As with cash, the anonymity allowed by cryptocurrencies may facilitate criminal

How do cryptocurrencies fit into our analysis of money?

• But cryptocurrencies are currently little used as a traditional medium of exchange –

• In light of these observations, it may be better to think of people holding

3. Money and Assets As Stores of Value:

PREPARED BY CHEN AIDI 12

If the nominal return on money is 𝒊𝒎 , what is the implied real return?

• Inflation is defined as a general rise in prices quoted in terms of money. Inflation

PREPARED BY CHEN AIDI 13

PREPARED BY CHEN AIDI 14

• Observe that (1+ 𝑟𝑚 )(1+𝜋) = 1 + 𝑖𝑚 implies 1+ 𝑟𝑚 + 𝜋+ 𝑟𝑚 𝜋= 1 + 𝑖𝑚 . If 𝑟𝑚 𝜋 is small

The Fisher Equation:

PREPARED BY CHEN AIDI 15

Ex-Ante and Ex- Post Interest Rates:

The opportunity cost of holding money:

• Money provides an important service in facilitating transactions as a medium of

PREPARED BY CHEN AIDI 16

Real And Nominal Interest Rates:

• In the earlier analyses of consumption, saving, and investment in Chapter 3 shows

• A time series of US real interest rates is shown in the figure below:

PREPARED BY CHEN AIDI 17

• Nominal interest rates are clearly positive on average, indicating a positive