Economics Chapter 5 Inflation, Deflation and the Money Market

Inflation and deflation Inflation A persistent increase in the general price level Deflation A persistent decrease in the general price level

Main features of inflation and deflation 1. Persistent Not once-and-for-all E.g. Tobacco tax  Price of cigarette  (price increases once only, not inflation) 2. General price level Overall increase/decrease in the prices of goods & services 3. Overall adjustment of the money price of goods During inflation Value of the money falls Purchasing power of money falls 4. Monetary phenomenon Too much money, but too few goods

Main features of inflation and deflation Relationship between money and inflation Inflation Persistence increase in general money prices If there is no money No money prices No inflation

The Quantity Theory of Money (QTM) ( 貨幣數量論 ) Basic concepts 1. Nominal income and real income 2. The velocity of circulation of money 3. The equation of exchange

The Quantity Theory of Money ( 貨幣數量論 ) 1. Nominal income and real income Real income (Y) Total output Quantity of production GDP at constant price Nominal income (PY) Monetary value of total output General price level (P) x Quantity (Y) GDP at market price

The Quantity Theory of Money ( 貨幣數量論 ) 2. The velocity of circulation of money Denoted as “ V ” Average number of times a unit of money is circulated (or changes hands) in a period to buy national output

The Quantity Theory of Money ( 貨幣數量論 ) Illustration A pays $100 for B’s product B’s income = $100 B pays $100 (income he gain from A) for C’s product C’s income = $100 The $100 circulated for the purchases = 2 times Velocity of circulation of money in this year = 2 AC $100 Output Value = $100 Output Value = $100 B

The Quantity Theory of Money ( 貨幣數量論 ) Try this Assume the M s = $100 What is the velocity of circulation of this $100? The $100 circulated for the purchases = 5 times Velocity of circulation of money in this year = 5 AC $100 BFD E

The Quantity Theory of Money ( 貨幣數量論 ) Try this Assume the M s = $100 What is the velocity of circulation of this $100? The $100 circulated for the purchases = 6 times Velocity of circulation of money in this year = 6 The $100 finally goes to Mr. A A  $100  B  $100   $100   $100   $100   $100 

The Quantity Theory of Money ( 貨幣數量論 ) Try this In a one-man economy, assume the M s = $100 What is the velocity of circulation of this $100? The $100 circulated for the purchases = 0 times Velocity of circulation of money in this year = 0 The QTM cannot be used to explain anything. A  $100 

The Quantity Theory of Money ( 貨幣數量論 ) Try this In a barter system, with no M s What is the velocity of money? Since there is no money supply, Velocity of circulation of money cannot be measured The QTM cannot be used to explain anything. AB

The Quantity Theory of Money ( 貨幣數量論 ) Illustration A pays $100 for B’s product B’s income = $100 B pays $100 (income he gain from A) for C’s product C’s income = $100 The $100 circulated for the purchases = 2 times Velocity of circulation of money in this year = 2 AC $100 Output Value = $100 Output Value = $100 B

The Quantity Theory of Money ( 貨幣數量論 )

MV = PY

Explanation of inflation by the QTM 1. Long-term effects (Classical QTM) Assumptions The velocity of circulation of money is stable. Statistics show that velocity of M2 is quite stable. V is constant. Real nation income is constant. Price mechanism leads to full employment Full employment: resources and technology are fully utilized.  Production is maximized already. Y is constant.

Explanation of inflation by the QTM 1. Long-term effects (Classical QTM) According to the equation If V and Y are constant, When M S  5%  Price level  5% Conclusion:  M V =  P Y MV = PY %  M = %  P

Explanation of inflation by the QTM The Classical QTM in long run Given the equation with constant velocity of money constant real output When M s   P  M s   P  In order words, Expansionary monetary policy ( M s , r  )  Inflation ( P  ) Contractionary monetary policy ( M s , r  )  Deflation ( P  ) If V and Y are constant, When M S  5%  Price level  5% Conclusion: M V = P Y

Explanation of inflation by the QTM 1. Short–term effects (Modern QTM) Assumptions Modern economic explanation: If M s   Real income  (in short run) Expansion of firms Illustration M s   P  More profit  Firm expands production (i.e. Y  ) Market is finally back to equilibrium level (in long run)

Explanation of inflation by the QTM 1. Short–term effects (Modern QTM) Explanation: Given MV = PY where M = Money supply, V = Velocity of circulation of money, P = Price level, Y= Real income Velocity of money is constant In short run, M s   PY (nominal income)  That is, when M s   Both P & Y   M V =  (P Y)

Explanation of inflation by the QTM 1. Short-term effects (Modern QTM) According to the equation If V is constant, When M S  5%  Nominal income (PY)  5% Conclusion:  M V =  P Y MV = PY %  M = %  P+ %  Y

Explanation of inflation by the QTM Conclusion 1. Long-term effects (Classical QTM) V and Y are constant Increase in M s  Increase in P %  M s = %  P Inflation rate = Growth rate of M s Inflation occurs because of the increase in money supply  M V =  P Y

Explanation of inflation by the QTM For calculation Long-term effects (Classical QTM) %  M s = %  P Question: Given that the money supply grows at a rate 5% p.a.. Base on the classical QTM, what will be the yearly inflation rate? Answer: %  M s = %  P 5% = %  P  %  P = 5%  Yearly inflation rate = 5%

Explanation of inflation by the QTM Conclusion 2. Short–term effects (Modern QTM) V is constant Increase in M s  Increase in nominal income (PY)  Increase in P & Y %  M s = %  P + %  Y Inflation rate < Growth rate of M s Inflation occurs partly because of the increase in money supply  M V =  P Y

Explanation of inflation by the QTM For calculation Short-term effects (Modern QTM) %  M s = %  P + %  Y Question: Given that the money supply increase by 10% and the real income increases by 3% in the mean time. Base on the modern QTM, what will be the inflation rate? Answer: %  M s = %  P + %  Y 10% = %  P + 3%  %  P = 10% - 3% = 7%  Inflation rate = 7%

Explanation of inflation by the QTM Points to remember: 1.  M s =  P Increase in money supply leads to increase in price level There is inflation, but Not increase in inflation rate Question (textbook p.142): In the long run, if there is a persistent increase in money supply, the inflation rate will rise. True or false? Answer: It’s incorrect. The inflation rate will rise only when there is a persistent growth rate of the money supply. (i.e. Inflation rate = %  P = %  M s )

Explanation of inflation by the QTM Points to remember: 1.  % M s =  % P =  inflation rate Decrease in the growth rate of money supply leads to decrease in inflation rate Since there is still inflation, price level increases Question (textbook p.142): In the long run, if the growth rate of the money supply falls, the price level will fall. True or false? Answer: It’s incorrect. The price level will fall only when there is negative growth in the money supply. (i.e.  M s =  P) (Growth rate of M s  ≠ M s  )

Explanation of inflation by the QTM 3. Inflation is a monetary phenomenon Classical QTM: A persistent increase in money supply causes inflation. Explanation (Milton Friedman) Money is a medium of exchange (for transactions purposes) More money on hand, people will like to buy more goods, i.e. demand for goods increases Without increase in output, price level will rise. Conclusion There is too much money chasing too few goods. P ($) 0 S Q (units) P0P0 Q0Q0 D0D0 E0E0 P ($) 0 S1S1 Q (units) P0P0 P1P1 Q0Q0 Q1Q1 D0D0 D1D1 E1E1 E0E0 P2P2 S0S0

Practice Paper 1 Q.33 Which of the following statements about the classical quantity theory of money is INCORRECT? A. Both the velocity of circulation of money and the real output are assumed to be constant. B. Any change in money supply will lead to the same proportional change in nominal output. C. Deflation will occur when there is a continuous fall in money supply. D. Any change in price level will lead to the same proportional change in money supply.

Practice Paper 2 Q.14 The following table shows the balance sheet of the banking system of an economy: Assets ($ million) Liabilities ($ million) Reserves Deposits Loans Suppose the public in this economy always holds $500 million cash and the banking system never holds excess reserves. a. Calculate the monetary base and money supply of the economy. (2 marks) b. Suppose the central bank lowers the minimum reserve ratio of the banking system by 5%. i. Explain whether the monetary base of the economy changes. (2 marks) ii. Calculate the new money supply. Show your working. (4 marks) c. According to the quantity theory of money, explain how the above change in money supply affects the general price level in the long run. (4 marks)

Practice Paper 2 Q.14 The following table shows the balance sheet of the banking system of an economy: Assets ($ million) Liabilities ($ million) Reserves Deposits Loans Suppose the public in this economy always holds $500 million cash and the banking system never holds excess reserves. a. Calculate the monetary base and money supply of the economy. (2 marks) Monetary base = $1 000 million + $500 million = $1 500 million (1) Money supply = $4 000 million + $500 million = $4 500 million (1)

Practice Paper 2 Q.14

c. According to the quantity theory of money, explain how the above change in money supply affects the general price level in the long run. (4 marks) The equation of exchange: MV = PY, where M = money stock, V = V velocity of circulation of money, P = general price level and Y = real output (1) According to the quantity theory of money, which assuming V and Y are constant in long run, (1) an increase in M will result in a rise in P by the same percentage. (1) Increase in money supply = [ ($ $4500) / $4500 ] x 100% = 22.22% So, inflation rate is 22.22% (1)

Hyperinflation Highest monthly inflation rates in history Country Currency name Month with highest inflation rate Highest monthly inflation rate Equivalent daily inflation rate Time required for prices to double Hungary Hungarian pengő July × %207 %15 hours Zimbabwe Zimbabwe dollar November × %98 %24.7 hours Yugoslavia Yugoslav dinar January × 10 8 %64.6%1.4 days Germany German Papiermark October ,500 %20.9 %3.7 days Greece Greek drachma October ,800 %17.9 %4.3 days Taiwan Old Taiwan dollar May 19492,178 %11%6.7 days

Inflation and interest rates

In reality Loan agreement: in terms of nominal interest rates However, real interest rates affects our purchasing power Measure in nominal interest rate In terms of money: Borrow = $100 Interest = $10 Nominal interest rate = 10% If price of cup remains unchanged, i.e. $10 per cup, In terms of goods Borrow = 10 cups ($100) Interest = 1 cups Real interest rate = 10% Without inflation: Nominal interest rate = Real interest rate

Inflation and interest rates Measure in nominal interest rate In terms of money: Borrow = $100 Interest = $10 Nominal interest rate = 10% If price of cup increases, i.e. $11 per cup, In terms of goods Borrow = 10 cups ($100) Pay back = 10 cups ($110) Interest = 0 cups Real interest rate = 0% With inflation, The purchasing power of money reduces by 10% Nominal interest rate offsets the adverse effect of inflation on purchasing power In this case, realized real interest rate = 0%

Inflation and interest rates Mr. A has $100 Nominal interest rate = 10% Because of inflation: Real interest rate < 10%, B Loan out: $100 (Nominal interest rate=10%) Repay: $110 A Yr Price = $12/pcs A Buy now 10 pens Yr Price = $10/pcs Buy later 9 pens

Inflation and interest rates Formula: Realized real interest rate = Nominal interest rate – Actual inflation rate (Note that “realized” and “actual” are used because the value are already known.) Cases: 1. Nominal interest rate = Actual inflation rate, Realized real interest rate = 0% 2. Nominal interest rate > Actual inflation rate, Realized real interest rate > 0% 3. Nominal interest rate < Actual inflation rate, Realized real interest rate < 0%

Inflation and interest rates Question: If Peter borrows money from the bank with nominal interest rate 5%p.a. and the actual inflation rate in this year this is 3%, what is the realised real interest rate? Answer: Realized real interest rate = Nominal interest rate – Actual inflation rate = 5% - 3% = 2%

Inflation and interest rates

The Fisher equation * Irving Fisher ( ) Relationship between nominal interest rate real interest rate the anticipated inflation rate ( 預期通脹率 ) Fisher equation Nominal interest rate = Real interest rate + Anticipated inflation rate If anticipated inflation rate = 3% To compensate lender, borrower needs to pay 3% on top of the real interest rate to lender for the loss of purchasing power This 3% is known as inflation premium. 通脹溢價

The Fisher equation * From Fisher equation Nominal interest rate = Real interest rate + Anticipated inflation rate Real interest rate = Nominal interest rate – Anticipated inflation rate Example Nominal interest rate = 10% Anticipated inflation rate = 4% By using Fisher equation Real interest rate = 10% - 4% = 6% Explanation Making a loan is “expected” to yield a real return of 6%

The Fisher equation * Real interest rate in Fisher equation Real interest rate = Nominal interest rate – Anticipated inflation rate Inflation is anticipated only. Not accurate in reality. Real interest rate determined before making loan. Realized real interest rate when loan is due Realized real interest rate = Nominal interest rate – Actual inflation rate Inflation actually happened. Actual inflation rate in reality.

The Fisher equation * Real interest rate vs. Realized real interest rate Real interest rate = Nominal interest rate – Anticipated inflation rate Assume nominal interest rate = 10% If anticipated inflation rate = 3%, but actual inflation rate is 7% Base on the anticipation, lender agrees Real interest rate = 10% - 3% = 7% But when the loan is due, lender gets Realized real interest rate = 10% - 7% = 3% Lender has loss of 4% purchasing power because of the inaccurate anticipation of inflation.

The Fisher equation * Question: Suppose the real interest rate and the anticipated inflation rate are 8% and 10% respectively. (a) Find the nominal interest rate. (b) Suppose the actual inflation rate is 15%. Find the realized real interest rate. Answer: (a) From Fisher equation Nominal interest rate = Real interest rate + Anticipated inflation rate = 8% + 10% = 18% (b) Realized real interest rate = Nominal interest rate – Actual inflation rate = 18% - 15% = 3%

Redistributive effects* ( 再分配 ) Unanticipated inflation ( 非預期通脹 ) A situation that Actual inflation rate > Anticipated inflation rate Actual inflation rate < Anticipated inflation rate Causes income of some people to be transferred to others. Known as “redistributive effects” Think about Will there be the transfer of purchasing power? Who will gain? Who will lose?

Redistributive effects* Illustration Suppose there’s a loan agreement between two people. Mr. A (borrower) borrows $10,000 from Mr. B (lender) Mr. B: Wants to get 5% (real) interest from $10,000 loan Anticipated inflation rate = 3% From Fisher equation: Nominal interest rate = 5% + 3% = 8% i.e. Mr. B contracts with Mr. A $10,000 loan in return 8% nominal interest rate Case 1 One year later when the loan is due Actual inflation rate is 6% Realized real interest rate = nominal interest rate – actual inflation rate = 8% - 6% = 2%

Redistributive effects* Case 1: Inflation rate > Expected [i.e. Actual inflation rate (6%) > Anticipated inflation rate (3%)] To Mr. B (lender) Expected to get 5% real interest Finally got 2% real interest Lose To Mr. A (borrower) Expected to pay 5% real interest Finally paid 2% real interest Gain Conclusion Because of unanticipated inflation Real income transfers from lender to borrower Redistributive effects can be found

Redistributive effects* Illustration Suppose there’s a loan agreement between two people. Mr. A (borrower) borrows $10,000 from Mr. B (lender) Mr. B: Wants to get 5% (real) interest from $10,000 loan Anticipated inflation rate = 3% From Fisher equation: Nominal interest rate = 5% + 3% = 8% i.e. Mr. B contracts with Mr. A $10,000 loan in return 8% nominal interest rate Case 2 One year later when the loan is due Actual inflation rate is 1% Realized real interest rate = nominal interest rate – actual inflation rate = 8% - 1% = 7%

Redistributive effects* Case 2: Inflation rate < Expected [i.e. Actual inflation rate (1%) < Anticipated inflation rate (3%)] To Mr. B (lender) Expected to get 5% real interest Finally got 7% real interest Gain To Mr. A (borrower) Expected to pay 5% real interest Finally paid 7% real interest Lose Conclusion Because of unanticipated inflation Real income transfers from borrower to lender Redistributive effects can be found

Redistributive effects* Illustration Suppose there’s a loan agreement between two people. Mr. A (borrower) borrows $10,000 from Mr. B (lender) Mr. B: Wants to get 5% (real) interest from $10,000 loan Anticipated inflation rate = 3% From Fisher equation: Nominal interest rate = 5% + 3% = 8% i.e. Mr. B contracts with Mr. A $10,000 loan in return 8% nominal interest rate Case 3 One year later when the loan is due Actual inflation rate is 3% Realized real interest rate = nominal interest rate – actual inflation rate = 8% - 3% = 5%

Redistributive effects* Case 3: Inflation rate = Expected [i.e. Actual inflation rate (3%) = Anticipated inflation rate (3%)] To Mr. B (lender) Expected to get 5% real interest Finally got 5% real interest No gains or loses To Mr. A (borrower) Expected to pay 5% real interest Finally paid 5% real interest No gains or loses Conclusion Because of accurate anticipated inflation No real income transfers between borrower and lender No redistributive effects

Redistributive effects* Case study (p.149) Mr. Wong gives a 1-year loan to his friend Market interest rate = 9% per annum Anticipated inflation rate = 3% 1. What is the real interest rate and the inflation premium? Real interest rate = 9% - 3% = 6% Inflation premium = anticipated inflation rate = 3% 2. Suppose the actual inflation rate = 1% a. Inflation premium high enough to offset the loss of purchasing power? ( Yes / No ) b. What is the realized real interest rate? Realized real interest rate = Nominal interest rate – Actual inflation rate = 9% - 1% = 8%, which is higher than anticipated.

Redistributive effects* Conclusion: Lenders vs. Borrowers If actual inflation rate > anticipated inflation rate Lenders lose Borrowers gain If actual inflation rate < anticipated inflation rate Lenders gain Borrowers lose If actual inflation rate = anticipated inflation rate No one gains or loses

Redistributive effects* II.Employers vs. Employees Suppose the employers pay fixed nominal wage to employees. Case 1: Inflation rate > Anticipated inflation rate To employers Pay fixed nominal wage Higher inflation  Lower purchasing power of the same unit of money i.e. Pay lower real wage Gain To employees Get fixed nominal wage Higher inflation  Lower purchasing power of the same unit of money i.e. Get lower real wage Lose

Redistributive effects* II.Employers vs. Employees Suppose the employers pay fixed nominal wage to employees. Case 2: Inflation rate < Anticipated inflation rate To employers Pay fixed nominal wage Lower inflation  Higher purchasing power of the same unit of money i.e. Pay higher real wage Loses To employees Get fixed nominal wage Lower inflation  Higher purchasing power of the same unit of money i.e. Get higher real wage Gain

Redistributive effects* Conclusion: Employers vs. Employees If actual inflation rate > anticipated inflation rate Employers gain Employees lose If actual inflation rate < anticipated inflation rate Employers lose Employees gain If actual inflation rate = anticipated inflation rate No one gains or loses

Redistributive effects* III.Government vs. Taxpayers Inflation usually raises nominal wage. In HK (progressive tax): Higher wage  Higher salary tax Case: Inflation rate > Expected To taxpayers Higher nominal wage  Higher tax rate  Higher real tax payment Higher inflation offsets the purchasing power of income i.e. No increase in real wage Lose To government Higher nominal wage  Higher tax rate  Higher real tax revenue Gains

Redistributive effects* Conclusion: Government vs. Taxpayers If actual inflation rate > anticipated inflation rate Government gains Taxpayers lose People argue that during the time of high inflation, the government take away taxpayers’ real income (i.e. purchasing power of money they earn). It’s somehow like a “robbery” from the citizen. Income disparity is more serious, esp. to the middle class.

Redistributive effects* III.Government vs. The root class Government pays fixed amount in CSSA Scheme. (Comprehensive Social Security Assistance) Real expenditure is lowered. Case: Inflation rate > Expected To CSSA recipients Fixed nominal amount in CSSA Scheme Higher inflation  Lower real amount received Lose To government Fixed expenditure Higher inflation  Lower real expenditure Gains

Redistributive effects* Conclusion: Government vs. The root class If actual inflation rate > anticipated inflation rate Government gains Poor people lose People argue that during the time of high inflation, the government spends less to help the poor. Income disparity is more serious, esp. to the root class.

Redistributive effects* IV.Transaction with deferred payment Agreement to pay later e.g. buying a TV set with 24-month installments Case: Inflation rate > Anticipated inflation rate To buyers Fixed nominal amount of payment Higher inflation  Lower real payment Gain To sellers Fixed nominal amount to receive Higher inflation  Lower real receipt Lose

Redistributive effects* Others: If actual inflation rate > anticipated inflation rate Depositors vs. Banks Depositors lose Banks gain Insurance policy holders vs. Insurance company Policy holder (with fixed amount of claim) lose If a person dies, get $1million (fixed nominal claim) However, $1 million means less real amount after inflation, esp, after many years. Insurance company gain

Full anticipated inflation If the inflation rate is fully anticipated Actual inflation rate = Anticipated inflation rate Realized real interest rate = Anticipated real interest rate Remember the 2 equations Realized real interest rate = Nominal interest rate + Actual inflation rate Real interest rate = Nominal interest rate + Anticipated inflation rate So, all wages, gov’t expenditures, etc. will be adjusted according to the accurately forecast inflation rate No redistributive effects

Indexing and inflationary expectation Indexing Adjustment of future income or payment according to the price inde x Example Real interest rate for a one-year loan = 5% Case 1 When the loan is due, and the actual inflation rate is 3% Borrowers need to pay a nominal rate = 5% +3% = 8% Case 2 When the loan is due, and the actual inflation rate is 10% Borrowers need to pay a nominal rate = 5% +10% = 15% Floating nominal interest rate Can offset the income distributive effects under inflation or deflation

Self-study: Redistributive effects 1. Think about different situations 1. Actual inflation rate > Anticipated inflation rate 2. Actual inflation rate < Anticipated inflation rate 3. Actual inflation rate = Anticipated inflation rate 2. Think about deflation 1. Actual deflation rate > Anticipated deflation rate 2. Actual deflation rate < Anticipated deflation rate 3. Actual deflation rate = Anticipated deflation rate 3. Ask yourself, who will gain and who will lose in the above situations.

Money demand (M d ) Assets people have: Money (cash & deposits) Shares Bonds Properties (house, apartment, flat) What is money demand? Mr. A’s total asset: $1,000,000 [Money(40%) + Shares(40%) + Bonds(20%)] Demand of money = The quantity of money (40% of $1,000,000) he holds In other words, money demand means how much cash and deposit people want to hold.

Motive for holding money Why do people need to hold money? 1. Transaction demand for money People need money to buy things Daily transaction 2. Asset demand for money Keep the value of asset As a store of value

Motive for holding money 1. Transaction demand for money As a medium of exchange Daily transaction at Fast food shop newspaper stand taxi Hold money for later use Enable consumption any time

Motive for holding money Transaction demand for money and real income If real income  More willing to buy things  Consumption  Need more money for transaction  Transaction demand for money  If real income  Better to save money  Consumption  No need to have money for transaction  Transaction demand for money 

Motive for holding money Transaction demand for money The demand for money as a medium of exchange. It is positively related to real income Higher real income  Higher money demand for transaction

Motive for holding money 2. Asset demand for money As a store of value Holding money (cash & demand deposits) No interest returns Lower risk Higher liquidity Holding bonds / shares Interest earning Risk of value change Lower liquidity

Motive for holding money 2. Asset demand for money Suppose 2 types of assets only Holding money means giving up interest earning Forgone nominal interest return from bonds Nominal interest rate   Cost of holding money   Demand of holding money   Asset demand for money  Nominal interest rate   Cost of holding money   Demand of holding money   Asset demand for money 

Motive for holding money 2. Asset demand for money Nominal interest rate   Asset demand for money  Nominal interest rate   Asset demand for money  The demand for money as a store of value: It is negatively related to the nominal interest rate. When nominal interest rate is high  quantity demanded of money is low; when nominal interest rate is low  quantity demanded of money is high.

The effects of price level on money demand Holding money is usually for transaction Amount to hold depends of the real value of money i.e. the value of goods (purchasing power of money) Nominal money balance = The face value of total amount of money Real money balance = The real value in terms of purchasing power

The effects of price level on money demand Real demand for money (10 boxes of chocolate) Price levelNominal demand for money 10$10$100 10$20$200

Other factors affecting the money demand Payment technology Octopus card / EPS / Credit card / Paypal Cash transaction  Cost to convert asset to cash  e.g. spending time to withdraw cash at the ATM  Demand of money  Risk associated with other assets Risk of losing value of bonds, shares or real estate  Demand of money 

Other factors affecting the money demand Inflationary expectation Fisher equation: Nominal interest rate = Real interest rate + Anticipated inflation rate If anticipated inflation rate   Nominal interest rate   Cost of holding cash   Demand of money   Higher the anticipated inflation rate  Lower the money demand

Interest-rate determination in the money market 1. Money demand curve Higher the interest rate  Lower the money demand Downward sloping Interest rate (%) Quantity of money Q1Q1 Q2Q2 r1r1 r2r2 MdMd 0

Interest-rate determination in the money market Interest-rate related If nominal interest rate drops from 3% to 2%  Quantity demanded of money increases from $100 to $120 Movement along the money demand curve Interest rate (%) Quantity of money MdMd 0

Interest-rate determination in the money market Income related If real income , M d shifts rightward from M d 1 from M d 2 If real income , M d shifts leftward from M d 1 from M d 3 Interest rate (%) Quantity of money Md1Md1 0 Md2Md2 Md3Md3

Interest-rate determination in the money market 2. Money supply curve Controlled by the government (monetary policy)  Vertical M s curve Expansionary monetary policy ( M s  )  M s curve shifts rightward from M s 1 from M s 2 Contractionary monetary policy ( M s  )  M s curve shifts leftward from M s 1 from M s 3 Interest rate (%) Quantity of money Ms1Ms1 0 Ms2Ms2 Ms3Ms3 MsMs MsMs Interest rate (%) Ms1Ms1 0 Quantity of money

Interest-rate determination in the money market 3. Equilibrium interest rate Interest rate is at the level that money demand equals money supply. M d = M s Interest rate (%) MsMs 0 Quantity of money MdMd r Equilibrium interest rate

Interest-rate determination in the money market Excess demand for money Interest rate is lower than the equilibrium interest rate M d > M s Money shortage Excess supply for money Interest rate is higher than the equilibrium interest rate M s > M d Surplus of money Interest rate (%) MsMs 0 Quantity of money MdMd r Excess demand MsMs 0 MdMd r Interest rate (%) Quantity of money Excess supply

Changes in the interest rate Change in money demand Increase in the money demand Reason: increase in real income  more transaction Money demand curve shifts rightward (from M d 1 to M d 2 ) Interest rate  (from r 1 to r 2 ) Interest rate (%) MsMs 0 Quantity of money Md2Md2 r1r1 r2r2 Md1Md1

Changes in the interest rate Change in money demand Decrease in the money demand Reason: decrease in real income  less transaction Money demand curve shifts leftward (from M d 1 to M d 2 ) Interest rate  (from r 1 to r 2 ) Interest rate (%) MsMs 0 Quantity of money Md2Md2 r1r1 r2r2 Md1Md1

Changes in the interest rate Question: (p.162) Suppose the GDP for Country A rises. With the aid of a diagram, explain how this will affect the interest rate of Country A. Answer: As GDP is the measure of the national income, rise in GDP means increase in income, which will lead to increase in money demand. The money demand curve shifts rightward from M d 1 to M d 2. Interest rate increases from r 1 to r 2. Interest rate (%) MsMs 0 Quantity of money Md2Md2 r1r1 r2r2 Md1Md1

Changes in the interest rate Change in money demand and money supply at the same time Increase in the money supply Reason: Expansionary monetary policy Money supply curve shifts rightward (from M s 1 to M s 2 ) Interest rate  (from r 1 to r 2 ) Interest rate (%) MdMd 0 Quantity of money Ms2Ms2 r1r1 r2r2 Ms1Ms1

Changes in the interest rate Change in money demand and money supply at the same time Decrease in the money supply Reason: Contractionary monetary policy Money supply curve shifts leftward (from M s 1 to M s 2 ) Interest rate  (from r 1 to r 2 ) Interest rate (%) MdMd 0 Quantity of money Ms2Ms2 r1r1 r2r2 Ms1Ms1

Changes in the interest rate Change in money demand and money supply at the same time Money demand   Interest rate  Money supply   Interest rate  Case 1: M d  = M s   Interest rate remains unchanged Interest rate (%) Md1Md1 0 Quantity of money Ms2Ms2 r1r1 Ms1Ms1 Md2Md2

Changes in the interest rate Change in money demand and money supply at the same time Money demand   Interest rate  Money supply   Interest rate  Case 2: M d  > M s   Interest rate  Interest rate (%) Md1Md1 0 Quantity of money Ms2Ms2 r1r1 Ms1Ms1 Md2Md2 r2r2

Changes in the interest rate Change in money demand and money supply at the same time Money demand   Interest rate  Money supply   Interest rate  Case 3: M d  < M s   Interest rate  Interest rate (%) Md1Md1 0 Quantity of money Ms2Ms2 r1r1 Ms1Ms1 Md2Md2 r2r2

Changes in the interest rate Change in money demand and money supply at the same time Money demand   Interest rate  Money supply   Interest rate  Case 1: M d  = M s   Interest rate remains unchanged Interest rate (%) Md1Md1 0 Quantity of money Ms2Ms2 r1r1 Ms1Ms1 Md2Md2

Changes in the interest rate Change in money demand and money supply at the same time Money demand   Interest rate  Money supply   Interest rate  Case 2: M d  > M s   Interest rate  Interest rate (%) Md1Md1 0 Quantity of money Ms2Ms2 r1r1 Ms1Ms1 Md2Md2 r2r2

Changes in the interest rate Change in money demand and money supply at the same time Money demand   Interest rate  Money supply   Interest rate  Case 3: M d  < M s   Interest rate  Interest rate (%) Md1Md1 0 Quantity of money Ms2Ms2 r1r1 Ms1Ms1 Md2Md2 r2r2