Macroeconomics

The Linkages Among Money, Prices, and Interest Rates 

This figure illustrates

the relationships among money, prices, and interest rates. Money supply and money

demand determine the price level. Changes in the price level determine the inflation

rate. The inflation rate influences the nominal interest rate. Because the nominal

interest rate is the cost of holding money, it may affect money demand. This last link

(shown as a blue line) is omitted from the basic quantity theory of money.

F I G U R E

4 - 5

Inflation 

Rate

Price

Level 

Money

Supply

Money

Demand

Nominal

Interest

Rate

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This announcement causes people to expect higher money growth and high-

er inflation. Through the Fisher effect, this increase in expected inflation rais-

es the nominal interest rate. The higher nominal interest rate increases the

cost of holding money and therefore reduces the demand for real money bal-

ances. Because the Fed has not changed the quantity of money available today,

the reduced demand for real money balances leads to a higher price level.

Hence, expectations of higher money growth in the future lead to a higher

price level today.

The effect of money on prices is complex. The appendix to this chapter pre-

sents the Cagan model, which shows how the price level is related to current and

expected future monetary policy. In particular, the analysis concludes that the

price level depends on a weighted average of the current money supply and the

money supply expected to prevail in the future.