1. 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.

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. The Demand for Money
The demand for money curve slopes downward

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

9. 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.

10. 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.

11. 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.

12. 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.

13. 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 = = 4.14%
As the price paid for a bond increases, the yield (interest rate) falls.

14. 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.

15. 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

16. 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.

18. Interest Rate Determination

19. 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.

20. 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.

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

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

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

25. 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.

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

27. 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.

28. 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.

29. 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

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

31. 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.

32. Quantity Theory of Money

33. 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.

34. 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.

35. Quantity Theory of Money

36. Quantity Theory of Money
Decade averages show stronger relationship

37. Quantity Theory of Money
International Evidence