The Role of Money and Credit

1
Chapter 3

• The Role of Money and Credit

2
Chapter 3 overview

• Much of this is review from what we have been
  talking about
• Fed Policy and the Economy
• Money supply and its effects on the economy
• Demand for money, supply of money
• interest rates

3
Interest Rate

• Interest rate
• The cost to borrowers for obtaining money
• The return on money for lending money
• Note the relationship and be able to tie back to
  model of the financial system

4
Interest rates

• Actually many different interest rates
• Short-term, long-term, government debt, risky
  debt, etc.
• For simplicity sake we often merely group them
  and say interest rate, but they do not
  necessarily move together as evidenced by Fed
  rate hikes last week that led to LT rates falling

5
Demand for Money

• Distinction between demand and quantity demanded
• Ceteris paribus, for any given demand curve,
  there is an inverse relationship between money
  demand and interest rates.
• WHY?

6
Demand for money

• As interest rates increase, there is a higher
  opportunity cost of holding cash. Thus, people
  do not desire as much cash so the quantity of
  demand drops.
• Note again the difference between demand curves
  (here merely called demand) and quantity
  demanded.)

7
Demand for money

• The actual demand (demand curve) for money is
  influenced by many things
• spending plans
• wealth
• preferences
• example as we spend more, or plan on spending
  more, we need more money

8
Demand for money

• A change in demand is actually a new demand
  curve.
• A change in the quantity of money demanded is a
  change along the same demand curve

9
Money Supply

• More complicated than money demand
• definition the stock of money in the hands of
  the public plus checkable deposits (hence M1)

10
Money Supply

• To issue checkable deposits a depository
  institution must hold reserves
• Reserves are assets held as either vault cash or
  in special accounts with the Fed
• In effect these reserves are out-of
  circulation. Thus by raising the reserve
  requirements, the Fed can reduce the money supply.

11
Money Supply

• As the supply of money is largely influenced by
  the reserve requirements, the supply of money is
  MUCH less influenced by interest rates than is
  the quantity demanded of money
• See exhibits 3-2 and 3-3

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Determination of interest rates

• Where supply demand
• Exhibit 3-3
• if demand for funds is great then the equilibrium
  rate will rise. If demand drops, so too will
  interest rates.

13
Determination of interest rates

• If money supply increases, the immediate SHORT
  TERM effect will be to have a lower interest
  rate.
• However, be careful as the Ceteris Paribus
  assumption is probably incorrect here!

14
Interest rates and the Supply of Money

• As Exhibit 3-7 shows, Money supply growth is
  associated with inflation. Thus we can not
  maintain our ceteris paribus assumption.
• With inflation comes higher interest rates. So
  the expected immediate effect of an increase in
  interest rates is unclear. Often depends on the
  maturity of loan

15
Credit

• Simplistic look at how credit influences the
  economy
• This again is tied back to our original model of
  the financial system. Looking at the SSUs
  willingness (and ability) to lend money to DSUs.

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Credit

• To understand this it helps to consider a second
  definition of the money supply DNFD.
• DNFD domestic non-financial debt
• Like increases in other money supply measures,
  increases in credit will cause spending (and
  incomes) to go up.

17
All I want is some Credit!

• Credit can greatly influence spending.
• Example a mortgage, credit cards etc. In each
  case the presence of credit will lead to spending
  that would otherwise not be possible
• Due to innovations and non-bank lending, the Fed
  is losing its ability to control credit
  availability

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Money, credit, and the economy

• Tying it all together
• increases in either money or credit will lead to
  increased spending and economic growth.
• Exhibit 3-6 shows how this is true with respect
  to real GDP

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Money, credit, and inflation

• Not only do money supply and credit increases
  lead to an improved economy, they also lead to
  inflation
• Exhibit 3-7
• Due to its tighter relationship with inflation,
  the Fed has been focusing more on DNFD than other
  supply measures