Nominal Money Supply Vs Real Money Supply
Nominal Money Supply Vs Real Money Supply Definition
Differentiate Between Nominal Money Supply And Real Money Supply
Nominal Money Supply Vs Real Money Supply

The consequences of unfettered printing of paper moneywere deemed undesirable in several places in the previous Topic.Now we turn to an analysis of the effects of excess money growth.The discussion focuses on the determinants of the price level.It will be recalled that the price level is the average ofall prices in the economy, taken as a percentage of that sameaverage in some earlier base period. And inflation is the growthor increase, on average, of prices---the annual rate of inflationis the year-to-year percentage growth of the price level.

Prices measure the amount of money that has to be given up toobtain units of the goods in question. Correspondingly, the pricelevel measures the amount of money that has to be given up to buya unit of the average good in the economy---or, roughly, a unit ofaggregate output. The amount of output one must give up to obtaina unit of money is therefore equal to the reciprocal of the pricelevel. The inverse of the price level thus represents what a unitof money is worth in terms of goods, or the value of money.So the question of what determines the price level boils down tothe question of what determines its reciprocal or the value of money.

It is natural to think of the value of money as determinedin the same way as the value of any other good or service---by thesupply and demand for it. Analysis of the supply and demand formoney differs slightly from that of the supply and demand for typicalgoods produced in the economy because money holdings are a stockwhile goods produced are flows. This difference is not substantivehowever---we simply measure the stock of money held by the public onthe horizontal axis of our supply and demand graph instead of thequantity of a good purchased per unit time. The determination of the price level can thus be analyzed with respect to Figure 1. The nominal money stock is on the horizontal axis and the value of money---whichequals 1/P where P is the price level---is on the vertical one.

Ideally, we conceive of the stock of money as the amountof liquidity in the economy. You will recall that liquidity is anattribute possessed by assets that represents the ease with whichthey can be converted into a predictable amount of cash for makingexchange. Most assets possess some degree of liquidity but only cashis completely liquid. Because assets possess varying degrees ofliquidity, we can only imperfectly measure the quantity of liquidityin the economy. The two most common measures of the quantity ofliquidity---that is, the money supply---are M1, which equals cash plus demand deposits, and M2, which equalscash plus both demand and time deposits. For the remainderof this Lesson we will simply think in terms of a conceptual stockof money that we will call M which can be approximately measured by either M1 or M2.

The supply curve in Figure 1 is thus a vertical line positionedto the right of the vertical axis by an amount equal to the existingstock of nominal money balances in circulation. When the centralbank increases the money supply this vertical line shifts rightward.The demand for nominal money stock, given by the curve DD, is downward sloping to the right like any demand curve. 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.

Suppose that the private sector holds a given nominal quantityof money M₀. The amount of transactions that can be made with that quantity of nominal money balances will depend on the price level---if the price level were to double, the existing nominal level of money holdings would finance only half of the previous volume oftransactions. People would require twice as big a nominal moneystock to provide the same level of transactions services. In otherwords, the amount of transactions services provided by money willdepend on the real stock of money, not the nominal stock.

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

Since the public decides on a desired real money stock, M/P, the rectangular area under DD associated with each given level of M will be a constant equal to 1/P times M, which will equal M/P. The demand curve for nominal money balances DD will thus be a rectangular hyperbola. A given rise in M will cause P to rise, and 1/P to fall, in the same proportion as that rise in M as we move along the curve.

If the central bank creates the quantity of money M₀, the equilibrium price level will be P₀. If it increases the quantity of money to M₁, the price level will rise to P₁and the value of money will fall to 1/P₁.

That is, the price level is directly related to the nominal money supply and to real money demand (which is a function of real income and the nominal interest rate). Using the above relationship between the aggregate price level, nominal money supply and real money demand we may derive a link between inflation, growth in the money supply. M V = nominal GDP M V = n o m i n a l G D P. The equation of exchange shows that the money supply M times its velocity V equals nominal GDP. Velocity is the number of times the money supply is spent to obtain the goods and services that make up GDP during a particular time period.

Having established the shape of the demand curve for nominalmoney holdings, we must now think about what will determine itslevel---that is, the level of desired real money holdings. Oneobvious factor will be the real flow of transactions, which canbe roughly measured by the level of real income. A rise in realincome, and the associated increase in the transactions demandfor money, will thus shift DD to the right as shown in Figure 2. A second factor will be the cost of holding money relative toother assets.

People hold money because it saves time and labour effort thatwould otherwise have to be devoted to arranging barter and checkingother people's credit ratings. That effort could have been devotedto producing goods and services for consumption and investment. Butthe choice of how much money to hold, and how much labour to thereby make available for other uses, will depend on how much income willbe sacrificed by holding additional money instead of other assets.Assuming that money holdings earn no interest, that sacrifice will bethe interest that could have been earned by holding bonds and otherassets instead of that additional money.Bonds and other assets that are fixed in nominal value willearn interest at, say, i percent. Real assets such as cars and TV sets will earn a return equal to, say, r percent. As we saw in the previous Lesson,Interest Rates and Asset Values, the difference betweenthe interest rates on nominal assets such as bonds and the returnon real assets such as cars and TV sets will be the expected rateof inflation. This is given by the Fisher equation

1. i = r + τ

where i is the nominal or market interest rate τ is the expected rate of inflation and r is the real interestrate. Since the real value of bonds will deteriorate at the expected rate τ, the real interest rate expected to be earned on them will equal r, the implicit interest rate earned on real assets. The interest rates implicitly earned on real assets do not contain premia for expected inflation because the market value of those assetswill rise with inflation along with the earnings on them. Of course,interest is not directly earned on real assets---earningson those assets are the streams of implicit or explicit rental incomefrom their use. The implicit interest rate on those assets is the ratio of those earnings to

Nomial Money Supply Vs Real Money Supply