MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL The demand for money Fed influences over interest rates Effect of Fed actions on AD, real GDP, and the price level in the short run & long run Quantity theory of money.

The Demand for Money The Determinants of Money Demand The quantity of money that people plan to hold depends on four main factors The price level The interest rate Real incomes (Real GDP) Financial innovation It is worth reminding students that “money” has a jargon sense in economics; students are often confused by the phrase “demand for money” and it is worth tackling it head-on by emphasizing this does not equate to “wanting to be rich,” but refers to how much of total wealth (assets) the public want to hold in the particular form “money.” Students often try to understand ideas in terms of their own lives; few will make a clear connection between interest rates and demand for money from their own introspection. There are two ways to overcome this: one is to ask them to think in terms of extreme situations (get what short-term interest rates are in a high-inflation country); the other is to get them to imagine themselves in the job of treasurer of a corporation with large liquid resources, and to think how their behavior with respect to those funds might differ according to the short-term interest rates available.

The Demand for Money The price level A rise in the price level increases the nominal quantity of money demanded doesn’t change the real quantity of money that people plan to hold. The quantity of nominal money demanded is proportional to the price level a 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent.

The Demand for Money The interest rate Real GDP the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset. A rise in the interest rate decreases the quantity of money that people plan to hold. Real GDP An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.

The Demand for Money Financial innovation That lowers the cost of switching between money and interest-bearing assets decreases the quantity of money that people plan to hold.

The Demand for Money The Demand for Money Curve Shows the relationship between the quantity of real money demanded (M/P) and the interest rate when all other influences on the amount of money that people wish to hold remain the same.

The Demand for Money The demand for money curve slopes downward

The Demand for Money Shifts in the Demand for Money Curve Real GDP Financial innovation

Interest Rate Determination An interest rate is the percentage yield on a financial security such as a bond or a loan. The price of a bond and the interest rate are inversely related. If the price of a bond falls, the interest rate on the bond rises. If the price of a bond rises, the interest rate on the bond falls.

The Bond Market. Bond features Coupon rate Maturity date is the specific future date on which the maturity value will be paid to the bond holder. Bond maturity dates when issued generally range from 3 months up to 30 years. Coupon rate Between the date of issuance and the maturity date, annual interest payment equals the coupon rate times the maturity value.

The Bond Market. Example: Yield to maturity the effective interest rate that the bond-holder earns if the bond is held to maturity. Bond price If P=maturity value, bond sells at “par”. If P>maturity value, bond sells above “par”. Example: Bond that matures 20 years from today with a maturity value of $1000 and a coupon rate of 10% will pay: $100 per year for 20 years $1000 at maturity The bond could be sold at any point in time for a price above or below its maturity value.

The Bond Market. Computing yields on one year bonds coupon rate = cr, maturity value =mv, price = P Yield = (MV+cr(MV))/P -1 = MV(1+cr)/P -1 As P rises, yield (interest rate) falls. If P=MV (par), yield=cr If P>MV (above par), yield<cr What is the yield on a one year bond that has a maturity value of 1000 and coupon rate of 8% if price equals $900 $950 $1050 As bond prices rise, yields (interest rates) fall.

The Bond Market. Computing yields on Zero Coupon Bonds. No interest payments are made between the sale of the bond and its maturity. yield = (MV/P)1/T – 1 If you buy a zero coupon bond today for $1000 and it has a maturity value of $1500 in 10 years yield = (1500/1000)1/10 -1 = .0414 = 4.14% As the price paid for a bond increases, the yield (interest rate) falls.

The Bond Market. Determinants of bond yields Inflation risk. Term Risk Debt rating agencies: Moody’s & Standard and Poors AAA=superior quality C=imminent default Inflation risk. Term Longer term bonds have greater inflation and default risk.

The Bond Market. Yield curve Shows relationship between yield and term on government bonds Slope of yield curve reflects Expectations of future short term interest rates Greater risk of long term bonds If short term interest rates are expected to be constant in the future, yield curve will slope upward reflecting risk premia for longer term bonds. A steepening of the yield curve suggests that financial markets believe short term interest rates will be rising in the future. The dynamic yield curve The bond market

Interest Rate Determination Money Market Equilibrium The Fed determines the quantity of money supplied and on any given day, that quantity is fixed. The supply of money curve is vertical at the given quantity of money supplied. Money market equilibrium determines the interest rate.

Interest Rate Determination

Interest Rate Determination If the Fed increases the money supply, interest rates will fall. As money supply increases, banks have more loanable funds, interest rates are reduced. Fed has better control over short term than long term rates. The reason that an increase in the money supply lowers the interest rate can be easily developed by focusing on banks. To increase the money supply, the Fed increases excess reserves. Banks want to loan these new excess reserves, and thus the supply of loans increases. As a result, the interest rate on loans falls as they struggle to make more loans. This type of intuitive explanation often can be quite helpful in supplementing the formal analysis.

Short-Run Effects of Money on Real GDP, and the Price Level Ripple Effects of Monetary Policy If the Fed increases the interest rate, three events follow: Investment and consumption expenditures decrease. The value of the $ rises and net exports decrease. A multiplier process unfolds.

Short-Run Effects of Money on Real GDP, and the Price Level

Short-Run Effects of Money on Real GDP, and the Price Level

Short-Run Effects of Money on Real GDP, and the Price Level

Short-Run Effects of Money on Real GDP, and the Price Level The Fed tightens the money supply to reduce inflationary pressure. Real GDP decreases and the price level falls.

Short-Run Effects of Money on Real GDP, and the Price Level Effects of an Increase in the money supply to recover from recession.

Short-Run Effects of Money on Real GDP, and the Price Level Limitations of Monetary Stabilization Policy The impact depends on the sensitivity of expenditure plans to the interest rate. The effects of monetary policy can take a long time be realized. These effects are variable and hard to predict.

LR Effects of Money on Real GDP and the Price Level An increase in the money supply will increase AD. SR Effects: Real wage falls Unemployment falls Real GDP increases. Price level rises.

LR Effects of Money on Real GDP and the Price Level Movement to new LR equilibrium the money wage rate rises SAS decreases. RGDP decreases P rises Compared to original LR equil. No change in RGDP, unempl, real wage Higher prices, nominal GDP & nominal wage

Quantity Theory of Money Equation of exchange MV = Py M=money supply V=velocity of money P=price level y=real GDP

Quantity Theory of Money MV = PY Q-theory assumes that velocity and potential GDP are not affected by the quantity of money. P = (MV/Y) Because (V/Y) does not change when M changes, a change in M brings a proportionate change in P.

Quantity Theory of Money

Quantity Theory of Money P = (V/Y)M Divide this equation by P = (V/Y)M and the term (V/Y) cancels to give P/P = M/M P/P is the inflation rate M/M is the growth rate of the quantity of money.

Quantity Theory of Money Historical Evidence on the Quantity Theory of Money U.S. money growth and inflation are correlated more so in the long run than the short run broadly consistent with the quantity theory.

Quantity Theory of Money

Quantity Theory of Money Decade averages show stronger relationship

Quantity Theory of Money International Evidence