The existence of money in a modern economy is usually taken for granted.

It performs three main functions. First, it is a unit of account; second, it is a universally accepted means of payment; and third, it is a store of value.

In models without money, one can only analyze the determination of real variables, such as the quantities of goods and services produced and consumed, and their relative prices.

In this chapter, we focus on the money market to analyze the supply and the demand for money and the determination of nominal variables.

Monetary conditions in modern economies are determined by central banks. A central bank can affect, through a variety of policy instruments at its disposal, both interest rates and the money supply. The money supply consists of the quantity of bank notes (and coins) in circulation and the stock of deposits in commercial banks. Thus, central banks can indirectly affect the money supply, although they usually operate through short-term interest rates, intervening in the money market and determining nominal interest rates. If the central bank follows a policy of pegging interest rates, the stock of money in the economy is determined indirectly by the demand for money, as the money supply adapts to demand, so that it is consistent with the target of the central bank regarding nominal interest rates.

The demand for money depends on three main factors. The first factor is the price level. The higher the level of prices is, the higher will be the amount of money that households and firms will want to hold for their current and future transactions. The demand for money is usually assumed to be proportional to the price level. This demand stems from the roles of money as both a unit of account and a means of payment.

The second factor is the volume of transactions, usually measured by aggregate real output and income. When the volume of transactions increases, households and firms will need more money to carry out their increased transactions. This determines the demand for real money balances, and it stems from the role of money as a means of payments.

The third factor is the level of nominal interest rates. Banknotes pay no interest. In contrast, demand deposits and current accounts in commercial banks, even when they pay interest, yield a very low return compared to the yields of less-liquid assets that are not means of payments, such as time deposits, treasury bills, and bonds. In what follows, we shall maintain the assumption that money pays no interest. Thus, as interest rates rise, households and firms will want to hold a smaller part of their assets in the form of money compared to interest-yielding assets, such as bonds and other less-liquid assets. Consequently, the demand for money will be assumed to depend negatively on the level of nominal interest rates.

In this chapter, we first review the basic functions of money and the factors that determine the supply and the demand for money. We analyze the concept of short-run equilibrium in the money market, assuming that the central bank follows a policy of either targeting the money supply or pegging nominal interest rates. We also discuss the notion of the long-run neutrality of money.¹

We then focus on some dynamic general equilibrium models with money. We analyze the determination of the price level and nominal interest rates and dicuss the long-run relationship between the money supply, the price level, and inflation.

Finally, we examine incentives for increasing the money supply and the effects of continuous increases of the money supply on inflation. The most important motive for sustained large increases in the money supply by governments has been the incentive to finance government expenditure that could not be financed by other methods (such as additional taxes or government bonds).

We first analyze the case in which the maximum income from seigniorage in equilibrium is adequate for the financing needs of a government, although these financing needs are large. In such a case, an economy will end up in an equilibrium with high inflation. Second, we analyze the case in which the maximum revenue from seigniorage is not sufficient for the financing needs of the government. In this case, an economy will end up with a hyperinflation, which is a disequilibrium phenomenon. The government will try to increase the rate of growth of the money supply continuously. This accelerating rate of growth of the money supply will eventually result in hyperinflation.

The main cause of all episodes of sustained high inflation or even hyperinflation has been the need of governments to use their privilege of printing money to obtain significant amounts of seigniorage.

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