Relationship between price level and nominal money supply

The Exchange Rate and the Price Level

relationship between price level and nominal money supply

Interconnection of Interest Rate, Price Level, Money Supply and Real GDP: The Case G.G. Booth, C. CinerThe relationship between nominal interest rates and . is the relationship between inflation and the growth rate of the nominal money supply. In equilibrium, the price level is proportional to the nominal money supply ;. The exchange rate has an important relationship to the price level because it represents a link between domestic prices and foreign prices. respect to monetary policythey are forced to create a specific equilibrium nominal money supply.

This relationship is called the law of one price. If every good produced in the domestic economy is also produced in the foreign economy, and if the shares of each good in aggregate output are the same in both economies, then the domestic price level will equal the exchange rate times the foreign price level.

Suppose that the government decides to fix the price of its currency in terms of some foreign currencythat is, adopt a fixed exchange rate. By fixing the exchange rate, the domestic authorities tie their hands with respect to monetary policythey are forced to create a specific equilibrium nominal money supply. As a matter of policy, the government can control either the domestic money supply or the country's exchange rate but not both.

When the government fixes the exchange rate, it invokes a natural mechanism that keeps the domestic money supply at its equilibrium level. In order to fix the exchange rate, the government must stand ready to purchase or sell domestic currency for foreign currency at its announced price.

If the domestic money supply is too high, people will spend the excess abroad, buying foreign currency with home money to enable those purchases. This will cause the price of foreign currency in terms of domestic currency to be bid up.

To maintain the exchange rate at the official level, the government has to sell foreign currency for domestic currency, taking home money out of circulation in the process. For the purpose of doing this, it keeps reserves of foreign currency on handthe country's stock of foreign exchange reserves.

If the domestic money supply is too low, the opposite will happen.

Finance: Chapter Effect of a Price Level Increase (Inflation) on Interest Rates

Too much will be sold abroad and people will be exchanging too much foreign currency for domestic currency. The government has to buy foreign currency to keep the price of foreign currency in terms of domestic currency from falling below the official level. This increases the country's stock of foreign exchange reserves and puts additional domestic money in circulation. The government can choose, of course, to not purchase and sell foreign currency for domestic currency when there are excess sales or purchases by domestic residents abroad.

In the analysis in the other Topics in this Lesson, we always assume flexible exchange rates. This enables us to think about domestic money and prices without worrying about what is happening in the rest of the world. We will be four Lessons further along in the sequence before we look again at exchange rates, and a full understanding of how they are determined and their relationship to domestic economic policy will only emerge with completion of the entire sequence of Lessons.

Nevertheless, before concluding this present Lesson we need to discuss further the law of one price and the relationship between the domestic and foreign price levels. In order to write down Equation 2 we had to assume that all goods are produced everywhere and can be freely bought and sold across international boundaries without the impediment of transport costs, tariffs, taxes, or subsidies, so that Equation 1, the law of one price, holds for every good.

Then we also assumed that each good represents the same fraction of aggregate output in each country so that countries' price indexes which are assumed to be output-weighted averages of the prices of goods produced are the same when the currencies exchange for each other on a one-for-one basis.

Effect of a Price Level Increase (Inflation) on Interest Rates

Of course, none of these assumptions are true, so how does the analysis change when they are false? Transport costs, taxes, tariffs and subsidies are not a problem because we can think of prices as being net of these distortions.

Analysis of the supply and demand for money differs slightly from that of the supply and demand for typical goods produced in the economy because money holdings are a stock while goods produced are flows. This difference is not substantive howeverwe simply measure the stock of money held by the public on the horizontal axis of our supply and demand graph instead of the quantity of a good purchased per unit time.

The determination of the price level can thus be analyzed with respect to Figure 1. Ideally, we conceive of the stock of money as the amount of liquidity in the economy. You will recall that liquidity is an attribute possessed by assets that represents the ease with which they can be converted into a predictable amount of cash for making exchange.

What Determines the Price Level?

Most assets possess some degree of liquidity but only cash is completely liquid. Because assets possess varying degrees of liquidity, we can only imperfectly measure the quantity of liquidity in the economy. The supply curve in Figure 1 is thus a vertical line positioned to the right of the vertical axis by an amount equal to the existing stock of nominal money balances in circulation. When the central bank increases the money supply this vertical line shifts rightward.

It is not, however, a straight line. The reason is that people make their decisions on how much money to hold on the basis of the real, not the nominal, quantity. The amount of transactions that can be made with that quantity of nominal money balances will depend on the price levelif the price level were to double, the existing nominal level of money holdings would finance only half of the previous volume of transactions.

People would require twice as big a nominal money stock to provide the same level of transactions services. In other words, the amount of transactions services provided by money will depend on the real stock of money, not the nominal stock.

People will thus decide on an appropriate level of real money holdings and then accumulate the stock of nominal money balances needed to provide those real holdings. Thus, given desired real money holdings, the nominal quantity of money demanded will vary in direct proportion with the price level and in inverse proportion with the nominal value of money.

Having established the shape of the demand curve for nominal money holdings, we must now think about what will determine its levelthat is, the level of desired real money holdings. One obvious factor will be the real flow of transactions, which can be roughly measured by the level of real income.

A second factor will be the cost of holding money relative to other assets.

relationship between price level and nominal money supply

People hold money because it saves time and labour effort that would otherwise have to be devoted to arranging barter and checking other people's credit ratings. That effort could have been devoted to producing goods and services for consumption and investment.

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But the choice of how much money to hold, and how much labour to thereby make available for other uses, will depend on how much income will be sacrificed by holding additional money instead of other assets.

Assuming that money holdings earn no interest, that sacrifice will be the interest that could have been earned by holding bonds and other assets instead of that additional money. As we saw in the previous Lesson, Interest Rates and Asset Valuesthe difference between the interest rates on nominal assets such as bonds and the return on real assets such as cars and TV sets will be the expected rate of inflation.

This is given by the Fisher equation 1. The interest rates implicitly earned on real assets do not contain premia for expected inflation because the market value of those assets will rise with inflation along with the earnings on them.

Of course, interest is not directly earned on real assetsearnings on those assets are the streams of implicit or explicit rental income from their use.

relationship between price level and nominal money supply

The implicit interest rate on those assets is the ratio of those earnings to their present value. The opportunity cost of holding money instead of other assets is thus equal to the nominal interest rate. The higher the nominal interest rate, the smaller will be the desired level of real money holdings.