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Money and Banking: The behavior of interest rates

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Title: Money and Banking: The behavior of interest rates


1
Money and Banking The behavior of interest rates
  • Spring 2007
  • Martin Andreas Wurm
  • University of Wisconsin - Milwaukee

2
The 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

3
The 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

4
The 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)

5
The 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.

6
The 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.

7
The behavior of interest rates
  • 5. The Liquidity Preference Framework

i
i0
i1
M
Md1
Md0
8
The 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

9
The behavior of interest rates
  • 5. The Liquidity Preference Framework

i
Ms
i
E
Md
M
Md Ms
10
The 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

11
The 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.)

12
The 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)

13
The 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?

14
The 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!

15
The behavior of interest rates
  • 5. The Liquidity Preference Framework

i
Ms
E1
i1
i0
E0
Md1
Md0
M
Md0 Md1Ms
16
The 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

17
The 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

18
The behavior of interest rates
  • 5. The Liquidity Preference Framework

i
Ms0
Ms1
E0
i0
E1
i1
Md1
Md0
M
Md Ms1
Md Ms0
19
The 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.

20
The 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
21
The 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.

22
The 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).

23
The 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
24
The behavior of interest rates
  • 6. Changes in the Money Supply and its Effect on
    Interest Rates

25
The 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.

26
The 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.

27
The 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).
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