Transcript Chap30

Chapter 30
Monetary Theory and Policy
© 2006 Thomson/South-Western
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Demand for Money
Refers to the relationship between how
much money people want to hold and the
interest rate
To carry out transactions
The greater the value of transactions to be
financed in a given period, the greater the
demand for money
Focus is on the medium of exchange
 Additionally, money serves as a store of
value; people demand money to carry out
market transactions
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Demand for Money
Advantage of money is its liquidity: it can
be immediately exchanged for whatever
needs to be purchased
Major disadvantage when compared to
other financial assets is that it earns no
interest
The interest forgone is the opportunity
cost of holding money
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Money Demand and Interest Rates
When the market rate of interest is low, other
things constant, the cost of holding money
(liquidity) is low: people hold a larger fraction of
their wealth in the form of money
Conversely, when the market rate of interest is
high, the cost of holding money is high: people
hold less of their wealth in money and more in
other financial assets
The quantity of money demanded, other things
constant, varies inversely with the market
interest rate
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Exhibit 1: Demand for Money
Money demand curve
slopes downward because at
lower interest rates, the
opportunity cost of holding
money is relatively low
Movements along the
curve reflect the impact of
changes in the interest rate
on the quantity of money
demanded
Assumed constant along
the curve are the price level
and real GDP
If either of these increases
(decreases), the demand for
money increases
(decreases): a rightward
(leftward) shift of the money
demand curve
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Supply of Money and the Equilibrium
Interest Rate
The supply of money is determined
primarily by the Fed through its control
over currency and over excess reserves
A vertical supply curve implies that the
quantity of money supplied is
independent of the interest rate
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Exhibit 2: Effect of an Increase in the Money Supply
Sm
Interest rate
The intersection of the demand for
money, Dm with the supply of money,
Sm determines the equilibrium
interest rate, i
If the FED increases the money
supply, the Sm curve shifts to the
right and the quantity supplied
exceeds the quantity demanded at
interest rate i
People now hold more of their
wealth as money than they would
like, so they exchange some for other
financial assets, such as bonds
As the demand for bonds
increases, bond sellers can pay less
interest, and the interest rate falls
and equals i'
Conversely, a decrease in the
supply of money would drive up
interest rates
i
S‘m
a
i'
b
Dm
0
M
M'
Quantity of
money
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Exhibit 3: Effects of an Increase in the Money Supply on
Interest Rates, Investment, Aggregate Expenditure,
Aggregate Demand
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Summary
 The sequence of events in Exhibit 3 can be summarized as
follows:
 An increase in the money supply, M, reduces the interest
rate, i. The lower interest rate stimulates investment
spending, I, which leads to an increase in aggregate
demand from AD to AD'. At a given price level, real GDP
demanded increases. The entire sequence is traced out in
Exhibit 3 by the movement from point a to b:
M  i  I  AD  Y
 As long as the interest rate is sensitive to changes in the
money supply, and as long as investment is sensitive to
changes in the interest rate, changes in the supply of
money affect planned investment
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Adding Short-Run Aggregate Supply
An aggregate supply curve can help show
how a given shift in the aggregate
demand curve affects real GDP and the
price level
In the short run, the aggregate supply
curve slopes upward: the quantity
supplied will expand only if the price
level increases
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Exhibit 4: Expansionary Monetary Policy to Correct a
Contractionary Gap
Potential
output
SRAS130
Price level
If the economy is
producing at point a where
the AD curve intersects
SRAS130, we havea shortrun equilibrium output of
$11.8 trillion and a price
level of 125
Actual price level is below
the expected price level of
130, and equilibrium level
of output is below the
economy’s potential: a
contractionary gap
The Fed can use monetary
policy to stimulate
investment, thus increasing
aggregate demand to AD',
attempting to move the
economy to point b
b
130
125
a
AD'
AD
0
11.8
12.0
Real GDP
(trillions of dollars)
Contractionary gap
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Exhibit 5: Recent Ups and Downs in the
Federal Funds Rate
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Equation of Exchange
One way of expressing the relationships among
key variables in the economy suggested by the
circular flow is the equation of exchange:
MxV=PxY
M = the quantity of money in the economy
V = the velocity of money, or the average number of
times per year each dollar is used to purchase final
goods and services
P = the price level
Y = real national output, or real GDP
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Equation of Exchange
The quantity of money in circulation multiplied
by the number of times that money turns over
equals the average price times real output: P
times Y equals nominal GDP
By rearranging the equation of exchange, we
would find that velocity equals nominal GDP
divided by the money stock
V = (P x Y) / M
The velocity of money indicates how often each
dollar is used on average to pay for final goods
and services during the year
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Quantity Theory of Money
If velocity is relatively stable over time,
or at least predictable, the equation of
exchange turns from an identity into a
theory – the quantity theory of money –
Quantity theory of money can be used to
predict the effects of changes in the
money supply on nominal GDP, P x Y
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Exhibit 6: In the Long Run, An Increase in the Money Supply
Results in a Higher Price Level, or Inflation
•An increase in the
money supply causes a
rightward shift of the
aggregate demand
curve, which increases
the price level but leaves
output unchanged at
potential GDP: the
economy’s potential
output level is not
affected by changes in
the money supply
•The implication of this
exhibit is that in the
long run, increases in
the money supply result
only in higher prices
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Velocity of Money
Velocity depends on:
 the
customs and conventions of commerce
electronic transmission of funds other
commercial innovations
 the
frequency with which workers get paid
The better money serves as a store of
value, the more of it people want to hold
and the lower its velocity
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Exhibit 7: The Velocity of Money –
Velocity of M1
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Exhibit 7: The Velocity of Money –
Velocity of M2
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Exhibit 8: A Decade of Annual Inflation and
Money Growth in 85 Countries
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Targets for Monetary Policy
The principal implication of the preceding
discussions is that monetary policy affects the
economy largely by influencing the interest rate
But in the long run, changes in the money
supply affect the price level, although with an
uncertain lag
Should monetary authorities focus on interest
rates in the short run or the supply of money in
the long run?
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Exhibit 9: Targeting Interest Rates
Versus Targeting the Supply of Money
Sm
Interest rate
The money market is in
equilibrium at point e
Suppose there is an
increase in the demand for
money shifting the demand
curve from Dm to D'm
Monetary authorities can
choose to do nothing,
allowing the interest rate to
increase from i to i', as we
move from e to e'
Or they can increase the
money supply in an attempt
to keep the interest rate
constant by increasing the
money supply from Sm to S'm
Monetary authorities must
choose from points lying
along the new money
demand curve, D'm
S'm
e'
i'
e
i
e"
D'm
Dm
0
M
M'
Quantity of money
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