Macro Week 2 The Money Market EC 100 Macro Week 2 The Money Market

Discussion of LT Week 2 Last week: discussed concept of fiscal policy multipliers – how does nominal GDP change if there is an increase in government expenditure? Note: we abstracted from what happens with prices (P), and we abstract with what happens on the capital markets (interest rates) in which the government needs to borrow in order to finance an increase in G. We saw: government multiplier > tax multiplier in absolute value We also saw: balanced fiscal policy (i.e. financing G with T) is not macroeconomically neutral. This week: begin exploring money and lending, the LM curve and combine this with the IS curve. We now explain two variables: (nominal) GDP Y and interest rates r.

Problem 1 Why would it be wasteful if the bank only kept all your money in its vaults until you wanted it back? In such a system, there would be no bank lending So loans could only be given from one individual to others to finance new ideas, startups or investment project Hence investment would fall Individuals who have excess funds may search for investment opportunities, such matching is however difficult (search cost etc) This is inherently inefficient, as institutionalized lending serves as a way to pool risks. A bank gives out loans, some are very successful – others are not – lending through bank combines these risks. Without fractional reserve banking – no real monetary policy through manipulation of reserve requirement ratio (see next problem).

Problem 2 Explain how the banking system as a whole creates more deposits from a given initial deposit at a single bank. The intuition is very similar to the case of the fiscal policy multipliers Imagine you put $ 100 into your bank account The bank is only required to keep $10 [depending on the reserve requirement] and can lend out the remaining $90. This is going to end up on somebody else’s bank account. Again, the bank only needs to keep $9 and can lend out the remaining $81. This again… keeps only $8.1$ and lends out the remaining $72.9$ This continues infinately How much money is created with the initial $100?

Problem 2 How much money is created with the initial $100? 100 + 90 + 81 + 72.9 + … + 100 * 0.9^t = 100 (1 + 0.9 + 0.9^2 + … 0.9^t) = 100 / (1-0.9) = 100/0.1 Money multiplier: ∆𝑀𝑆= 1 𝑑 ∆𝐻 where d is the reserve requirement (here d = 1/10)

Problem 3 Why do people willingly hold cash when those funds could instead be earning interest if deposited at a bank? Transactions motive: It is costly to go to the bank to get money for transactions. So individuals economize on this transaction cost by holding only the money they need for a particular time period in cash and putting the rest on the bank account. New technologies can reduce the transactions motive Examples… Safety/ insurance motive: Is it safe to trust the banks? What happens in case of a bank run? How do governments try to get you to trust the banks?

Problem 4 What effect would you expect a general rise in real interest rates (i.e., the excess of the rate of interest over the rate of inflation) to have on the demand of money? How would your behaviour change if a bank offered for your deposits an interest rate of 50 per cent per month? If real-return is high – opportunity cost of holding cash is very high…

Problem 4 Key distinction – again, I know this may sound stupid – ensure that you are always aware of whether you shift a line or you move along a line (and why). Here we are asked to think about how money demand changes as we move along the line (vary the real interest rate)

Problem 5 What are the effects of a fall in the money supply? Trace the effects through the money market into the goods market. First a very quick and easy answer It is important that you understand this process Verbally: The Central Bank reduces high-powered money (e.g. by selling bonds). There is a money-multiplier reduction in the money supply. The interest rate rises. Investment falls. GDP falls through the investment-spending multiplier effect.

Problem 5 Money market and Goods Market Five steps: a decrease in the monetary base leads to (1) a magnified fall in money supply via (2) the money supply multiplier, shifting leftwards the money-supply schedule, and leading to (3) an increase in the interest rate. A higher interest rate lowers investment, shifting downwards (4) the C+I+G schedule, leading to (5) a magnified reduction in equilibrium income.

Problem 5 This is only half the story… A fuller analysis studying the LM curve and IS curve. What happens to the LM curve? LM curve (all combinations of Y and R such that Money market in equilibrium) shfits to the left. IS curve: All combinations of Y and r consistent with equilibrium in the goods market Intersection of the two: gives levels of (Y,r) that are consistent with both money market equilibrium and goods market equilibrium. So we can tell this story using three pictures instead of two!

Problem 5 What does the third picture look like? (next weeks class more on this) – there is some crowding out going on. LM (MS‘) LM (MS) r1 r2 r0 IS Y1 Y0

Problem 6 Explain the meaning of the following actions by the Bank of England, and their effects on the money market and hence the goods market: (a) open market operations; (b) an increase in reserve requirements; and (c) an increase in the interest rate.

Problem 6 Open market operations: Suppose the government sells bonds (if it buys them, the direction of changes that follow are all reversed but the reasoning is comparable), taking money from the public for them. Then the public holds more bonds and less money. Via the money multiplier, the supply of money falls. Goods market effects… An increase in reserve requirements: The required increase in reserves lowers the money multiplier. Thus, for a fixed quantity of high-powered money, the supply of money falls. Goods market effects… An increase in the interest rate: This doesn’t change the money supply or demand schedules. However, the quantity of money demanded by the public falls, i.e., money market equilibrium slides up the money demand schedule. Goods market effects…

Problem 7 Explain the effects on GDP of (a) an increase in the money supply; (b) an increase in government spending in a model with a money market. Note part a) is the same as in Problem 5, just with the signs reversed (will now have a positive effect on GDP). Again, you should be able to show this… Only discuss part b)

Problem 7 b) (b) an increase in government spending in a model with a money market. Because we are interested in Y and r, we should also consider the IS-LM diagram First, let us talk through the process using the Goods Market and Money Market diagrams seperately The increase in G raises GDP through the government spending multiplier But this raises the interest rate (r) [WHY?] This lowers investment [WHY?] This is known as “crowding out” Hence, the overall increase in GDP is lower than we calculated last week: ∆𝒀< 𝟏 𝟏−𝒃 ∆𝑮

Problem 7 b) (b) an increase in government spending in a model with a money market. (1) the rise in government spending tends to increase GDP via the government spending multiplier. For a given level of the interest rate, the IS curve shifts to the right by the government expenditure multiplier <> you see the intersection happens now at a higher interest rate r* (2) how can we make the money market consistent with this? The money demand curve shifts to the right as we are now at a different level of GDP. How fAr does the curve need to shift? Far enough so that the intersection between money supply and demand now occurs such that the new equilibrium interest rate r* From the IS-LM diagram, 𝒀 𝟎 → 𝒀 𝟏 is the “full” government multiplier effect ∆𝒀= 𝟏 𝟏−𝒃 ∆𝑮 Because of the interest rate increase we only get 𝒀 𝟎 → 𝒀 ∗ hence ∆𝒀< 𝟏 𝟏−𝒃 ∆𝑮

Problem 7b) graphically Y1 – Y0 = 1/(1-b) * delta*(G1-G0) LM (MS) r* r0 IS(G1) IS(G0) Y0 Y1 Y*

Problem 8 In what ways can the government finance deficit spending (i.e., spending in excess of its tax revenues)? Recall the government budget constraint: an increase in government spending can be paid for by raising taxes, issuing more bonds, increasing the money supply, asset sales (the opposite of quantitative easing), or any combination of these. So a deficit (when ∆𝐺>∆𝑇) must be paid for by issuing bonds, increasing money supply or selling assets Explain the distinction between government debt and the government deficit Which of these methods have the UK government tried since the crisis?!