Choice, Change, Challenge, and Opportunity

1
27
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
CHAPTER
2
Objectives

• After studying this chapter, you will able to
• Explain what determines the demand for money
• Explain how the Fed influences interest rates
• Explain how the Feds actions influence spending
  plans, real GDP, and the price level in the short
  run
• Explain how the Feds actions influence real GDP
  and the price level in the long run and explain
  the quantity theory of money

3
Ripple Effects of Money

• There is enough money in the United States today
  for everyone to have a wallet stuffed with 2,300
  in notes and coins and another 19,000 in the
  bank.
• Why do we hold so much money?
• Through 2001, as the economy slowed, the Fed cut
  interest rates 11 times.
• In 2002 and 2003, the Fed cut the interest rate
  even further to historically low levels.
• How does the Fed change the interest rate and
  with what effects?

4
The Demand for Money

• The Influences on Money Holding
• The quantity of money that people plan to hold
  depends on four main factors
• The price level
• The interest rate
• Real GDP
• Financial innovation

5
The Demand for Money

• The price level
• A rise in the price level increases the nominal
  quantity of money but doesnt change the real
  quantity of money that people plan to hold.
• Nominal money is the amount of money measured in
  dollars.
• 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.

6
The Demand for Money

• The interest rate
• The interest rate is 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.

7
The Demand for Money

• Financial innovation
• Financial innovation that lowers the cost of
  switching between money and interest-bearing
  assets decreases the quantity of money that
  people plan to hold.

8
The Demand for Money

• The Demand for Money Curve
• The demand for money curve is 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.

9
The Demand for Money

• Figure 27.1 illustrates the demand for money
  curve.
• The demand for money curve slopes downward
• A fall in the interest rate lowers the
  opportunity cost of holding money and brings an
  increase in the quantity of money demanded--a
  movement downward along the demand for money
  curve.

10
The Demand for Money

• A rise in the interest rate increases the
  opportunity cost of holding money and brings an
  decrease in the quantity of money demanded--a
  movement upward along the demand for money curve.

11
The Demand for Money

• Shifts in the Demand for Money Curve
• The demand for money changes and the demand for
  money curve shifts if real GDP changes or if
  financial innovation occurs.

12
The Demand for Money

• Figure 27.2 illustrates an increase and a
  decrease in the demand for money.
• A decrease in real GDP or a financial innovation
  decreases the demand for money and shifts the
  demand curve leftward.
• An increase in real GDP increases the demand for
  money and shifts the demand curve rightward.

13
The Demand for Money

• The Demand for Money in the United States
• Figure 27.3 shows scatter diagrams of the
  interest rate against real M1 and real M2 from
  1970 through 2003 and interprets the data in
  terms of movements along and shifts in the demand
  for money curves.

14
The Demand for Money

• The Demand for Money in the United States
• Figure 27.3 shows scatter diagrams of the
  interest rate against real M1 and real M2 from
  1970 through 2003 and interprets the data in
  terms of movements along and shifts in the demand
  for money curves.

15
Interest Rate Determination

• An interest rate is the percentage yield on a
  financial security such as a bond or a stock.
• 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.
• We can study the forces that determine the
  interest rate in the market for money.

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.

17
Interest Rate Determination

• Figure 27.4 illustrates the equilibrium interest
  rate.

18
Interest Rate Determination

• If the interest rate is above the equilibrium
  interest rate, the quantity of money that people
  are willing to hold is less than the quantity
  supplied.
• They try to get rid of their excess money by
  buying financial assets.
• This action raises the price of these assets and
  lowers the interest rate.

19
Interest Rate Determination

• If the interest rate is below the equilibrium
  interest rate, the quantity of money that people
  want to hold exceeds the quantity supplied.
• They try to get more money by selling financial
  assets.
• This action lowers the price of these assets and
  raises the interest rate.

20
Interest Rate Determination

• Changing the Interest Rate
• Figure 27.5 shows how the Fed changes the
  interest rate.
• If the Fed conducts an open market sale, the
  money supply decreases, the money supply curve
  shifts leftward, and the interest rate rises.

21
Interest Rate Determination

• If the Fed conducts an open market purchase, the
  money supply increases, the money supply curve
  shifts rightward, and the interest rate falls.

22
Short-Run Effects of Money onReal 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 dollar rises and next exports decrease.
• A multiplier process unfolds.

23
Short-Run Effects of Money onReal GDP, and the
Price Level
Figure 27.6 summarizes these ripple effects.
24
Short-Run Effects of Money onReal GDP, and the
Price Level

• The Fed Tightens to Avoid Inflation
• Figure 27.7 illustrates the attempt to avoid
  inflation.

25
Short-Run Effects of Money onReal GDP, and the
Price Level

• A decrease in the money supply in part (a) raises
  the interest rate.

26
Short-Run Effects of Money onReal GDP, and the
Price Level

• The rise in the interest rate decreases
  investment in part (b).

27
Short-Run Effects of Money onReal GDP, and the
Price Level

• The decrease in investment shifts the AD curve
  leftward with a multiplier effect in part (c).

28
Short-Run Effects of Money onReal GDP, and the
Price Level

• Real GDP decreases and the price level falls.

29
Short-Run Effects of Money onReal GDP, and the
Price Level

• The Fed Eases to Avoid Recession
• Figure 27.8 illustrates the attempt to avoid
  recession.

30
Short-Run Effects of Money onReal GDP, and the
Price Level

• An increase in the money supply in part (a)
  lowers the interest rate.

31
Short-Run Effects of Money onReal GDP, and the
Price Level

• The fall in the interest rate increases
  investment in part (b).

32
Short-Run Effects of Money onReal GDP, and the
Price Level

• The increase in investment shifts the AD curve
  rightward with a multiplier effect in part (c).

33
Short-Run Effects of Money onReal GDP, and the
Price Level

• Real GDP increases and the price level rises.

34
Short-Run Effects of Money onReal GDP, and the
Price Level

• The size of the multiplier effect of monetary
  policy depends on the sensitivity of expenditure
  plans to the interest rate.
• Limitations of Monetary Stabilization Policy
• Monetary policy shares the limitations of fiscal
  policy, except that there is no law-making time
  lag or uncertainty.
• It also has the additional limitation that the
  effects of monetary policy are long drawn out,
  indirect, and depend on responsiveness of
  spending to interest rates.
• These effects are all variable and hard to
  predict.

35
Long-Run Effects of Money onReal GDP and the
Price Level

• In the long run, real GDP equals potential GDP.
• An increase in the quantity of money at full
  employment increases real GDP and raises the
  price level.
• The money wage rate rises, which decreases
  short-run aggregate supply and decreases real GDP
  but raises the price level.
• In the long run, an increase in the quantity of
  money leaves real GDP unchanged but raises the
  price level.

36
Long-Run Effects of Money onReal GDP and the
Price Level

• Figure 27.9 illustrates the effects of an
  increase in the quantity of money starting from
  potential GDP.
• In part (a), the Fed increases the quantity of
  money and lowers the interest rate.

37
Long-Run Effects of Money onReal GDP and the
Price Level

• In part (b), aggregate demand increases
• Real GDP increases to 10.2 trillion and the
  price level rises to 105.

38
Long-Run Effects of Money onReal GDP and the
Price Level

• With an inflationary gap, the money wage rate
  rises and short-run aggregate supply decreases.
• The SAS curve shifts leftward, real GDP decreases
  to 10 trillion and the price level rises to 110.

39
Long-Run Effects of Money onReal GDP and the
Price Level

• Back in the money market, the rise in the price
  level decreases the quantity of real money.
• The interest rate rises to 6 percent.

40
Long-Run Effects of Money onReal GDP and the
Price Level

• The Quantity Theory of Money
• The quantity theory of money is the proposition
  that, in the long run, an increase in the
  quantity of money brings an equal percentage
  increase in the price level.
• The quantity theory of money is based on the
  velocity of circulation and the equation of
  exchange.
• The velocity of circulation is the average number
  of times in a year a dollar is used to purchase
  goods and services in GDP.

41
Long-Run Effects of Money onReal GDP and the
Price Level

• Calling the velocity of circulation V, the price
  level P, real GDP Y, and the quantity of money M
• V PY/M.
• Figure 27.10 on the next slide graphs the
  velocity of circulation for M1 and M2 for
  19632003.

42
Long-Run Effects of Money onReal GDP and the
Price Level
43
Long-Run Effects of Money onReal GDP and the
Price Level

• The equation of exchange states that
• MV PY
• The quantity theory assumes that velocity and
  potential GDP are not affected by the quantity of
  money.
• So
• P (V/Y)M
• Because (V/Y) does not change when M changes, a
  change in M brings a proportionate change in P.

44
Long-Run Effects of Money onReal GDP and the
Price Level

• That is, the change in P, ?P, is related to the
  change in M, ?M, by the equation
• ?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 and ?M/M is the
  growth rate of the quantity of money.

45
Long-Run Effects of Money onReal GDP and the
Price Level

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

46
Long-Run Effects of Money onReal GDP and the
Price Level

• Figure 27.11 graphs money growth and inflation in
  the United States from 1963 to 2003.
• Part (a) shows year-to-year changes.

47
Long-Run Effects of Money onReal GDP and the
Price Level

• Part (b) shows decade average changes.

48
Long-Run Effects of Money onReal GDP and the
Price Level

• International Evidence on the Quantity Theory of
  Money
• International evidence shows a marked tendency
  for high money growth rates to be associated with
  high inflation rates.
• Figure 27.12 shows the evidence.

49
Long-Run Effects of Money onReal GDP and the
Price Level

• Correlation, Causation, and Other Influences
• Correlation is not causation money growth and
  inflation could be correlated because money
  growth causes inflation, or because inflation
  causes money growth, or because a third factor
  caused both.
• But the combination of historical, international,
  and other independent evidence gives us
  confidence that in the long run, money growth
  causes inflation.
• In the short run, the quantity theory is not
  correct we need the AS-AD model.

50
THE END