Title: Money and Banking: The behavior of interest rates
1Money and Banking The behavior of interest rates
- Spring 2007
- Martin Andreas Wurm
- University of Wisconsin - Milwaukee
2The behavior of interest rates
- 5. The Liquidity Preference Framework
- Other than the loanable funds framework there
exists another instrument to analyze interest
rates. - This instrument has been developed out of the
Keynesian model and is known as the Liquidity
Preference Framework - When Keynes wrote his General Theory of
Employment, Interest and Money in 1935 he made
the simplifying assumption that individuals could
hold their wealth only in two forms of assets
3The behavior of interest rates
- 5. The Liquidity Preference Framework
- Bonds B and Money (Cash) M.
- Note, that the amount of bonds and money demanded
in an economy must, thus, equal total wealth in
that economy. - In equilibrium the quantity of bonds and money
held in an economy must, then, equal their supply -
4The behavior of interest rates
- 5. The Liquidity Preference Framework
- The second equation above tells us something
about equilibrium in bonds and money markets - If the supply of bonds is equal to the demand for
bonds, the right hand side of this equation is
equal to zero. - As a consequence the second market must clear,
too, since the left hand side of this equation
must be zero as well in equilibrium (this is
known as Walras Law)
5The behavior of interest rates
- 5. The Liquidity Preference Framework
- Thus, the equilibrium interest rate in the bonds
market is also the one at which the money market
is in equilibrium! - We can, therefore, use demand and supply in the
(nominal) money market to analyze changes in the
interest rate. - This is especially helpful when we try to analyze
shifts in money supply and inflation.
6The behavior of interest rates
- 5. The Liquidity Preference Framework
- The key argument here is that holding money earns
no interest. - If this is the case, the interest rate on bonds
acts as the opportunity cost of holding money,
since every time you hold money, you forego
interest. - Thus, the demand for money will be negatively
related to the interest rate on bonds (in this
sense, the interest rate is the price of money)
as demonstrated in the following graph.
7The behavior of interest rates
- 5. The Liquidity Preference Framework
i
i0
i1
M
Md1
Md0
8The behavior of interest rates
- 5. The Liquidity Preference Framework
- The supply of money is assumed to be exogenous,
i.e. not determined within the model. - In reality the Ms is set by the Federal Reserve,
which makes this a somewhat plausible assumption. - The important feature of this assumption is that
Ms is not a function of the interest rate and
can, thus, be displayed as a vertical line in our
diagram
9The behavior of interest rates
- 5. The Liquidity Preference Framework
i
Ms
i
E
Md
M
Md Ms
10The behavior of interest rates
- 5. The Liquidity Preference Framework
- Where Ms and Md intersect the money market is in
equilibrium. - This point E0 corresponds to a specific
equilibrium interest rate which will also clear
the bonds market - We can now use this diagram to analyze interest
rate behavior induced by shifts in money demand
and money supply
11The behavior of interest rates
- 5. The Liquidity Preference Framework
- 1. There are two major determinants of money
demand - 1. Households income determines demand for money
for reasons of transactions - As an individuals income increases (e.g. during
a business cycle expansion), her or his demand
for money will increase, since her or his
consumption increases (et v.v.)
12The behavior of interest rates
- 5. The Liquidity Preference Framework
- There are two major determinants of money demand
- 2. Changes in the price level (in-/deflation). If
prices rise, the real value of money declines. - Thus, in order to keep the real purchasing power
of money constant, individuals will want to hold
a larger nominal amount of money in order to meet
their transactions demand. Thus, increases in
prices of goods c.p. lead to a higher nominal
demand for money (keeping the real demand Md/P
constant)
13The behavior of interest rates
- 5. The Liquidity Preference Framework
- If money demand increases for one of the two
reasons starting from an original equilibrium E0
in the graph below c.p. people will try to sell
their bonds for money. - However, the total supply of money in the economy
has not increased! How does the market return to
its equilibrium?
14The behavior of interest rates
- 5. The Liquidity Preference Framework
- The attempt of individuals to sell bonds will
lower the prices at which these bonds actually
sell and increase their interest rates. - Since this in turn increases the opportunity cost
of holding money, more individuals will be
willing to hold bonds again, such that in the new
equilibrium E1 interest rates have increased,
such that they exactly balance both markets
again. The aggregate quantities of money and
bonds held have not changed!
15The behavior of interest rates
- 5. The Liquidity Preference Framework
i
Ms
E1
i1
i0
E0
Md1
Md0
M
Md0 Md1Ms
16The behavior of interest rates
- 5. The Liquidity Preference Framework
- While an increase in the demand for money leads
to an increase in interest rates et vice versa,
an increase in money supply decreases interest
rates. - The argument here (simply speaking) works through
so called open market policies. If a central bank
from an equilibrium E0 increases the supply of
money it does so by buying bonds. This creates an
excess supply of money at the old equilibrium
interest rate and an excess demand for bonds
17The behavior of interest rates
- 5. The Liquidity Preference Framework
- The central bank decreases the supply of bonds
driving up the prices of these bonds, which in
turn lowers the interest rate. - Since this reduces the opportunity cost of
holding money, more individuals will be willing
to hold money again - This process is stopped once a new equilibrium E1
is reached. at which the additional money in
circulation is held by households
18The behavior of interest rates
- 5. The Liquidity Preference Framework
i
Ms0
Ms1
E0
i0
E1
i1
Md1
Md0
M
Md Ms1
Md Ms0
19The behavior of interest rates
- 5.The Liquidity Preference Framework
- Further, low interest rates are associated with
high investment levels, which in turn are
associated with higher economic growth and
well-being. - In the aftermath of the Keynesian revolution it
was common wisdom for a while to use increases in
money supply as a policy tool to fight off
recessions. - However, early critique of this approach was
brought forward by Milton Friedman and this
years nobel prize winner Edmund Phelps.
20The behavior of interest rates
- 6. Changes in the Money Supply and its Effect on
Interest Rates - The very short-run effect of an increase in the
money supply is a decrease in the interest rate
given money demand is the same. - However, as pointed out by Milton Friedman1, the
effectiveness of monetary policy is limited since
there are also secondary effects on money demand. - Other than the primary decrease in interest
rates, which he called liquidity effect, there
are income, price level and expected inflation
effects if the money supply is increased.
1 Friedman, Milton, The Role of Monetary
Policy, in AER, 1968, available through the
university servers under http//www.jstor.org/vie
w/00028282/di950399/95p01092/0
21The behavior of interest rates
- 6. Changes in the Money Supply and its Effect on
Interest Rates - One by one
- Income effect Increases in Ms increase national
income and, thus increase Md - leading to an
increase in i - Price level effect An increase in Ms increases
prices at least in the medium run (see the AS-AD
framework), which in turn will lead to increases
of Md and i - Finally, expected increases in Ms may lead to
higher expected inflation, which in turn will
lead to a lower demand for and higher supply of
bonds and, thus, to an increase in i.
22The behavior of interest rates
- 6. Changes in the Money Supply and its Effect on
Interest Rates - To summarize
- An increase in the money supply leads to a
decrease in i, the so called liquidity effect - An increase in the money supply leads to shifts
in money demand through the income, price level
and expected inflation effects all of which
increase i. - Which effect is stronger is an empirical
question, but an increase in the money supply
might very well increase interest rates! (see the
figures below).
23The behavior of interest rates
- 6. Changes in the Money Supply and its Effect on
Interest Rates
i
Ms0
Ms1
E2
i2
II
i0
E0
E1
i1
I
Md1
Md0
M
Md Ms1
Md Ms0
24The behavior of interest rates
- 6. Changes in the Money Supply and its Effect on
Interest Rates
25The behavior of interest rates
- 6. Changes in the Money Supply and its Effect on
Interest Rates - Some empirical evidence
- Milton Friedman and Ann Schwartz in their epochal
research A monetary history of the United
States (1963) have argued, that booms are
typically preceded by increases in the money
supply, while recessions are typically preceded
by decreases in the money supply. - From this observation they concluded that money
leads output and, hence, that there exists at
least some (although limited) room for the Fed to
affect growth through changes in the money supply.
26The behavior of interest rates
- 6. Changes in the Money Supply and its Effect on
Interest Rates - Some empirical evidence
- In the 1980 this hypothesis was put to test once
more by an econometrician named Christopher Sims. - Sims wrote a paper titled Macroeconomics and
Reality published in Econometrica in which he
argued that much of the logic of the Monetarism
vs. Keynesianism debate made unrealistic
assumptions about which factors are exogenous
policy variables and which ones are not.
27The behavior of interest rates
- 6. Changes in the Money Supply and its Effect on
Interest Rates - Some empirical evidence
- Using a newly developed statistical technique he
made a convincing point that the money supply
does neither very strongly affect output growth
nor interest rates. - In fact, his evidence suggests that the Fed (and
the same is likely for other central banks) sets
the money supply passively as a reaction to
macroeconomic variables it observes (most likely
according to inflation, output and/or interest
rates).