Sustainable and Nonsustainable Inflation Rates
This section presents a construct in which we can explore the impact of monetary growth, gross domestic product (GDP) growth, and interest rates on the overall price level. It also examines the inverse relationship between changes in the overall price level and interest rates. Despite the model’s admittedly simplistic nature, it is capable of providing some robust and intuitive results.
IMPACT OF MONETARY POLICY AND INTEREST RATES ON PRICE LEVEL CHANGES
The system’s first equation is the demand for money function, which can be stated as:
where M = nominal money supply
P = price level (e.g., gross domestic product price deflator)
Y = real GDP (i.e., nominal GDP divided by the price level)
K = a scaling factor
i = the yield-to-maturity (YTM) of long-term government bonds where payment is in nominal—and not inflation-adjusted—coupons and principal
α,β = positive constants
e = base of the natural logarithm
The model’s underlying assumption is that the nominal money supply, M, is under the determination and control of the governmental monetary authority and that supply and demand of real money balances, M/P, equilibrate virtually instantaneously through changes in any or all of the price level, the interest rate, and real GDP.
The model has mathematical properties that are very intuitive and easy to work with. We can start ...