Once again, we need to pause and allow for inflation. We recall that the interest rate here is the real rate of interest. It is determined by the supply of money. Shouldn't the quantity of money be adjusted for inflation, like just about everything else?

YES!

Is the answer. The stock of money and the amount loaned must, for consistency, be expressed as real money balances in this model.

Real money balance

A real money balance is the nominal value of the balance divided by a price index. In this way, the money balance is adjusted for inflation, so that a given real money balance has a stable purchasing power.

Inflation and Real Money Balances