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In the last few lectures (here, and here), we looked at extending the equilibrium business cycle to include changes in capacity utilisation, unemployed workers, and money demand.
In the last lecture, the demand for money was static. This lecture, we'll be allowing the money supply to grow and develop, and see how this affects inflation, economic growth, and interest rates.
Actual and Expected Inflation
If the price level in period 1 is 
and in year 2 be 
. The change in the price level over the two periods is 
. The inflation rate, 
, is the change in the price level over time.
Households don't know the future, so they have to forecast what they expect inflation to be in the future. Inflation changes the level of consumption over time, because it changes purchasing power in different periods.
How households form expectations is a matter of some controversy. The rational expectations hypothesis suggests households adjust their expectations about the future based on past information to avoid making too many big mistakes. Other theories of expectation formation associated with the economist GLS Shackle don't take this type of reasoning into account. The jury is still out on this issue in the profession.
The real interest rate is the nominal interest rate minus the inflation rate.
The real interest rate is assumed to be the rate at which the value of bonds change over time. The real interest rate affects the demand for money, and the intertemporal substitution effect households experience when trying to determine their optimal consumption paths through time, dependent on their budget constraints.
The intertemporal substitution effect is modulated by both the real interest rate, and the expected level of inflation.
Economists measure expectations by simply asking a sample of people how they feel about the future, and compare these sentiments to models which try to solve for expected inflation.
We'll be using these concepts in the lecture to get to a definition of what happens when money demand changes over the business cycle.
Slides
