Inflation and Real Money Balances

Notice what that means: an increase in the price level will reduce the real supply of money, and hence increase the interest rate, if the nominal supply of money remains unchanged. Similarly, a reduction in the price level will increase the real money supply and a reduction of interest, if the nominal money supply is constant.

Let's go through that in a little more detail. The overall price level goes up, but there is no increase in the supply of money. The real purchasing power of a certain number of dollars is cut, just because each dollar has less purchasing power. But, in addition to that, consumers and businessmen will need more money to do business. To get the money they will sell bonds -- pushing down the price of bonds and up the interest rate.

We can illustrate that yet again with Figure 2.

Figure 2(repeated): Liquidity Preference and Inflation

In this case we suppose that inflation has reduced the purchasing power of the unchanged number of dollars in circulation from M_b to M_a. To get more money to carry on their business at this higher price level, people would sell bonds, pushing the price of bonds downward and the interest rate upward to R_a.
Next:

Aggregate Demand