Money Supply/Demand

The Equilibrium Interest Rate [at “E”, money supplied ($200) = money demanded ($200)] The Equilibrium Interest Rate The Dm curve represents the quantity of money people are willing to hold at various interest rates. 7.5 5 2.5 MS Dm Notice nominal interest not real E Nominal Interest Rate 50 100 150 200 250 300 Billion Money Market The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy [in this case, 5%].

Figure 1 How the Supply and Demand for Money Determine the Equilibrium Price Level Value of Price Money, Quantity fixed by the Fed Money supply 1 / P Level, P (High) 1 Money demand 1 (Low) 3 / 1.33 4 A 1 / 2 2 Equilibrium value of money Equilibrium price level 1 / 4 4 (Low) (High) Quantity of Money

Demand For Money [Demand for “cash in hand”] For Daily, Weekly, & Monthly Transactions Mortgage/rent Utilities Gas Food Emergency money Tuition for kids Christmas gifts Transactions Demand, Dt M1 Independent of interest rate Direct with Nominal Y Medium of Exchange M1 Nominal Interest Rate Money demanded (bil.) Dt 10 7.5 5 2.5 0 50 100 150 200 250 300 Valentine candy for wife Gift for the girlfriend We keep this transaction money(M1) in our wallet, under our mattress, or in our checking accounts.

Rate of interest, i (percent) THE Total DEMAND FOR MONEY Transactions Demand, Dt [“make exchanges”] Asset Demand, Da [“hold wealth”] + = Total demand for money, Dm Da [M2] – store of value money Money that we don’t need for daily, weekly, or monthly transactions. We will invest more of it the higher the interest rate. We will hold less because the opportunity cost increases. “Walking around” money M1 Rate of interest, i (percent) Amount of money demanded (billions) 10 7.5 5 2.5 Da 0 50 100 150 200 250 Nominal Interest Rate Amount of money demanded (billions) Dt 10 7.5 5 2.5 0 50 100 150 200 250 300 Dt Independent of the interest rate Da 10% 8% 6% 4% 2% Interest Rate Opportunity Cost Da [hold less] Da [hold more] “I’m losing more interest, the higher the I.R.” CDs or 5% Da varies inversely with the interest rate. 1% 0 50 100 150 200

Money Demand This is a hard one to understand!!! Demand for money is not the need for money. It is how much you will choose to carry (in your pocket) It is very critical you understand the distinction.

What if you get a Raise in Income=you demand more money-nominal interest rates go up-inflation goes down! Value of Price Money, M1 MS1 1 / P Level, P Money demand (High) 1 Money demand 1 (Low) Nominal Interest Rates 3 / 1.33 4 A 1 / 2 2 B 1 / 4 4 (Low) (High) Quantity of Money

It makes since if you think about it It makes since if you think about it. Because you demand more money interest rates go up to attract your money to the banks to save. Because interest rates go up people put more money in the bank instead of caring it around which means people are spending less money which means the prices on things will go down.

Figure 2 An Increase in the Money Supply Value of Price Money, M1 MS1 M2 MS2 1 / P Level, P (High) 1 Money demand 1 (Low) 1. An increase in the money supply . . . 3 / 1.33 4 2. . . . decreases the value of mone y . . . 3. . . . and increases the price level. A 1 / 2 2 B 1 / 4 4 (Low) (High) Quantity of Money

The Equilibrium Interest Rate 7.5 5 2.5 MS Dm E Nominal Interest Rate 50 100 150 200 250 300 Billion Money Market

Money Demand 1. The interest rate: Higher Interest rates make you want to hold less money. Lower Interest rates make you want hold more money. (Like a Dot to Dot) 2. High Inflation-more demand for money Low inflation-lower demand for money 3. Income-more income more demand for money-you buy more stuff Less income-you demand less money-you don’t buy as much stuff.

Inflation make money demand go up! High Inflation means you need more money in your pocket to spend since the prices on things have gone up. In other words you have to carry more in you pocket to buy stuff. Lower inflation does the opposite.

Higher incomes Higher income make people buy more stuff. Therefore they need more in their pockets. Lower incomes make people buy less so they don’t carry any in their pocket because they don’t have any money anyway. This is a hard one to understand!!! Demand for money is not the need for money. It is how much you will choose to carry (in your pocket)

The Equilibrium Interest Rate [at “E”, money supplied ($200) = money demanded ($200)] Dm MS1 10% 7.5% 5% Excess supply of money Nominal Interest Rate E 0 50 100 150 200 250 300 Billion Money Market At a 7.5% interest rate, the amount of money in circulation is more than households and firms wish to hold. They will attempt to reduce their money holdings by buying bonds.

The Equilibrium Interest Rate [at “E”, money supplied ($200) = money demanded ($200)] MS1 Dm 10 7.5 5 2.5 Excess supply of money Nominal Interest Rate E Excess demand for money 0 50 100 150 200 250 300 Billion Money Market At 2.5%, households don’t have enough money to facilitate ordinary transactions. They will sell bonds and put the money in their checking accounts.

Money Supply, Money Demand, and Monetary Equilibrium The money supply is a policy variable that is controlled by the Fed. Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied. Money demand has several determinants, including interest rates and the average level of prices in the economy. Bullet 2: Mankiw has removed the word, “directly”

Money Supply, Money Demand, and Monetary Equilibrium People hold money because it is the medium of exchange. The amount of money people choose to hold depends on the prices of goods and services. In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

The Effects of a Monetary Injection The Quantity Theory of Money How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the economy determines the value of money. The primary cause of inflation is the growth in the quantity of money.

Velocity and the Quantity Equation The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. V = (P  Y)/M where: V = velocity P = the price level Y = the quantity of output M = the quantity of money

The real interest rate stays the same. The Fisher Effect The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate. According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same. The equation of the fisher effect must appear here or on a new next slide: “Nominal interest rate = real interest rate + inflation rate”

Figure 5 The Nominal Interest Rate and the Inflation Rate Percent (per year) 15 12 Nominal interest rate 9 6 Inflation 3 1960 1965 1970 1975 1980 1985 1990 1995 2000

THE COSTS OF INFLATION A Fall in Purchasing Power? Inflation does not in itself reduce people’s real purchasing power.

THE COSTS OF INFLATION Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth

Shoeleather Costs Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings. Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings. Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.

Shoe-leather Costs The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand. Also, extra trips to the bank take time away from productive activities.

Menu Costs Menu costs are the costs of adjusting prices. During inflationary times, it is necessary to update price lists and other posted prices. This is a resource-consuming process that takes away from other productive activities.