Transcript Economics Principles and Applications

The Demand For Money
 Don’t people always want as much money as
possible?
 Yes
 But when we speak about demand for
something, we don’t mean amount people
would desire if they could have all they wanted
 Without having to sacrifice anything for it
 Demand for money does not mean how much money
people would like to have in best of all worlds
 Rather, it means how much money people would like
to hold, given constraints they face
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An Individual’s Demand for Money
 At any given moment, total amount of wealth we have is
given
 If we want to hold more wealth in form of money, we must
hold less wealth in other forms (which are those?)
 These two facts determine an individual’s wealth constraint
 An individual’s quantity of money demanded
 Amount of wealth individual chooses to hold as money
 Rather than as other assets
 Why do people want to hold some of their wealth in form of
money?
 Money is a means of payments- other forms of wealth are
not used for purchase
 But the other forms of wealth provide a financial return to
their owners
 Money pays either very little interest (where?) or none at
all
 When you hold money, you bear an opportunity cost

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Interest you could have earned by holding other assets instead
An Individual’s Demand for Money
 Individuals choose how to divide wealth between two
assets
 Money, which can be used as a means of payment but
earns no interest
 Bonds, which earn interest, but cannot be used as a
means of payment
 What determines how much money an individual will
decide to hold?
 While tastes vary from person to person, three key
variables have rather predictable impacts on most of us
 Price level
 Real income
 Interest rate – opportunity cost of money?
 When we add up everybody’s behavior, we find a
noticeable and stable tendency for people to hold less
money when it is more expensive to hold money that is
 when the interest rate is higher
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The Demand for Money by
Businesses
 Some money is held by businesses
 Stores keep some currency in their cash
registers
 Firms generally keep funds in business checking
accounts
 They have only so much wealth, and they
must decide how much of it to hold as
money rather than other assets
 They want to hold more money when real
income or price level is higher
 Less money when opportunity cost (interest
rate) is higher
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The Economy-Wide Demand For
Money
 Just as each person and each firm in economy has only
so much wealth
 There is a given amount of wealth in the economy as a
whole at any given time
 Total wealth must be held in one of two forms
 Money or bonds
 Economy-wide quantity of money demanded
 Amount of total wealth all households and businesses,
together, choose to hold as money rather than as bonds
 Demand for money depends on the same three variables
that we discussed for individuals
 A rise in the price level will increase demand for money
 A rise in real income (real GDP) will increase demand for
money
 A rise in interest rate will decrease demand for money
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The Money Demand Curve
 Figure 1 shows a money demand
curve
 Tells us total quantity of money
demanded in economy at each interest
rate
 Curve is downward sloping
 As long as other influences on money
demand don’t change
 A drop in interest rate—which lowers the
opportunity cost of holding money—will
increase quantity of money demanded
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Figure 1: The Money Demand
Curve
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Shifts in the Money Demand Curve
 What happens when something other
than interest rate changes quantity of
money demanded?
 Curve shifts
 A change in interest rate moves us
along money demand curve
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Figure 2: A Shift in the Money
Supply Curve
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Figure 3: Shifts and Movements Along the
Money Demand Curve—A Summary
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The Supply of Money
 Just as for money demand, we would like to draw a curve
showing quantity of money supplied at each interest rate
 Interest rate can rise or fall, but money supply will
remain constant unless and until Fed decides to change it
 Suppose Fed, for whatever reason, were to change money
supply
 Would be a new vertical line
 Showing a different quantity of money supplied at each
interest rate
 Open market purchases of bonds inject reserves into
banking system
 Shift money supply curve rightward by a multiple of
reserve injection
 Open market sales have the opposite effect
 Withdraw reserves from system

Shift money supply curve leftward by a multiple of reserve
withdrawal
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Figure 4: The Supply of Money
Interest
Rate
6%
3%
s
M1
s
M2
E
J
500
700
Money
($ Billions)
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Equilibrium in the Money
Market
 Key Step #3
 Combines what you’ve learned about money demand
and money supply to find equilibrium interest rate in
economy
 We are interested in how interest rate is determined
in short-run
 In short-run we look for the equilibrium interest rate
in money market
 Interest rate at which quantity of money demanded
and quantity of money supplied are equal
 Important to understand what equilibrium in money
market actually means
 Remember that money supply curve tells us quantity
of money that actually exists in economy
 Determined by Fed
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Equilibrium in the Money
Market
 Money demand curve tells us how much
money people want to hold at each interest
rate
 Equilibrium in money market occurs when
quantity of money people are actually holding
(quantity supplied) is equal to quantity of
money they want to hold (quantity
demanded)
 Can we have faith that interest rate will reach
its equilibrium value in money market?
 Yes
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Figure 5: Money Market
Equilibrium
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How the Money Market Reaches
Equilibrium
 If people want to hold less money than they are
currently holding, then, by definition
 They must want to hold more in bonds than they are
currently holding
 An excess demand for bonds
 When there is an excess supply of money in economy
 There is also an excess demand for bonds
 Can illustrate steps in our analysis so far as follows
 Conclude that, when interest rate is higher than its
equilibrium value, price of bonds will rise
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An Important Detour: Bond Prices
and Interest Rates
 A bond, in the simplest terms, is a promise to pay
back borrowed funds at a certain date or dates in the
future
 When a large corporation or government wants to
borrow money, it issues a new bond and sells it in the
marketplace
 Amount borrowed is equal to price of bond
 The higher the price, the lower the interest rate
 General principle applies to virtually all types of bonds
 When price of bonds rises, interest rate falls
 When price of bonds falls, interest rate rises
 Relationship between bond prices and interest rates
helps explain why government, press, and public are
so concerned about the bond market
 Where bonds issued in previous periods are bought
and sold
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Back to the Money Market
 Complete sequence of events
 Can also do the same analysis from the other
direction
 Would be an excess demand of money, and an excess
supply of bonds
 In this case, the following would happen
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What Happens When Things
Change?
 Focus on two questions
 What causes equilibrium interest rate to
change?
 What are consequences of a change in
the interest rate?
 Fed can change interest rate as a
matter of policy, or
 Interest rate can change on its own
 As a by-product of other events
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How the Fed Changes the Interest
Rate
 Changes in interest rate from day-to-day, or week-to-week,
are often caused by Fed
Fed officials cannot just declare that interest rate should be
lower

 Fed must change the equilibrium interest rate in the money
market
 Does this by changing money supply
The process works like this

 Fed can raise interest rate as well, through open market
sales of bonds

Setting off the following sequence of events
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How the Fed Changes the Interest
Rate
 If Fed increases (decreases)
money supply by buying
(selling) government bonds, the
interest rate falls (rises)
 By controlling money supply
through purchases and sales of
bonds, Fed can also control the
interest rate
 What is the effect of this change
in the economy?
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Figure 6: An Increase in the
Money Supply
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How Do Interest Rate Changes
Affect the Economy?
 If Fed increases money supply
through open market purchases of
bonds
 Interest rate will fall
 How is the macroeconomy affected?
 A drop in the interest rate will boost
several different types of spending in the
economy
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How the Interest Rate Affects
Spending
 Lower interest rate stimulates business
spending on plant and equipment
 Remember that the interest rate is one of the
key costs of any investment project
 A firm deciding whether to spend on plant
and equipment compares benefits of
project—increase in future income—with
costs of project
 Interest rate changes also affect spending
on new houses and apartments that are
built by developers or individuals
 Loan agreement for housing is called a
mortgage
 Mortgage interest rates tend to rise and fall
with other interest rates
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How the Interest Rate Affects
Spending
 Interest rate affects consumption spending on big
ticket items
 Such as new cars, furniture, and dishwashers
 Economists call these consumer durables because
they usually last several years
 Can summarize impact of money supply changes as
follows
 When Fed increases money supply, interest rate falls,
and spending on three categories of goods increases
 Plant and equipment
 New housing
 Consumer durables (especially automobiles)
 When Fed decreases money supply, interest rate
rises, and these categories of spending fall
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Monetary Policy and the Economy
 Fed—through its control of money supply—has power to
influence real GDP
 When Fed controls or manipulates money supply in order
to achieve any macroeconomic goal it is engaging in
monetary policy
 To find final equilibrium in economy, would need quite a bit
of information about how sensitive spending is to drop in
the interest rate



As well as how changes in income feed back into money
market to affect interest rate
This is what happens when Fed conducts open market
purchases of bonds
Open market sales by Fed have exactly the opposite effects

Equilibrium GDP would fall by a multiple of the initial decrease in spending
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Figure 7(a): Monetary Policy and
the Economy
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Figure 7(b): Monetary Policy and
the Economy
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An Increase in Government
Purchases



What happens when government changes its fiscal policy
 Say, by increasing government purchases
Increase in government purchases will set off multiplier
process
 Increasing GDP and income in each round
Increase in government purchases, which by itself shifts the
aggregate expenditure line upward
 Also sets in motion forces that shift it downward
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An Increase in Government
Purchases
 At the same time as the increase in government
purchases has a positive multiplier effect on GDP
 Decrease in a and I have negative multiplier effects
 In short-run, increase in government purchases causes
real GDP to rise
 But not by as much as if interest rate had not increased
 Aggregate expenditure line is higher, but by less than ΔG
 Real GDP and real income are higher
 But rise is less than [1/(1 – MPC)] x ΔG
 Money demand curve has shifted rightward
 Because real income is higher
 Interest rate is higher
 Because money demand has increased
 Autonomous consumption and investment spending are
lower
 Because the interest rate is higher
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Figure 8(a): Fiscal Policy and the
Money Market
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Figure 8(b): Fiscal Policy and the
Money Market
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Crowding Out Once Again
 When effects in money market are included in shortrun macro model
 An increase in government purchases raises interest
rate and crowds out some private investment
spending
 May also crowd out consumption spending
 In classical, long-run model, an increase in
government purchases also causes crowding out
 In short-run, however, conclusion is somewhat
different
 While we expect some crowding out from an increase
in government purchases, it is not complete
 Investment spending falls, and consumption spending
may fall, but together, they do not drop by as much
as rise in government purchases
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 In short-run, real GDP rises
Other Spending Changes
 Positive shocks would shift aggregate expenditure line
upward
 Increases in government purchases, investment, net
exports, and autonomous consumption, as well as
decreases in taxes, all shift aggregate expenditure line
upward
 Real GDP rises, but so does interest rate
 Rise in equilibrium GDP is smaller than if interest rate
remained constant
 Negative shocks shift aggregate expenditure line downward
 Decreases in government purchases, investment, net
exports, and autonomous consumption, as well as
increases in taxes, all shift aggregate expenditure line
downward
 Real GDP falls, but so does interest rate
 Decline in equilibrium GDP is smaller than if interest rate
remained constant
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What About the Fed?
 In our analysis of spending shocks, we’ve
made an implicit but important assumption
 Assumed Fed does not change money supply in
response to shifts in aggregate expenditure line
 While this assumption has helped us focus
on the impact of spending shocks
 It is not the way Fed has conducted policy
during past few decades
 Has used monetary policy to prevent spending
shocks from changing GDP at all
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Are There Two Theories of the
Interest Rate?

In classical model, interest rate is determined in market for
loanable funds

In this chapter you learned that interest rate is determined in
money market


Which theory is correct?



Both
Why don’t we use classical loanable funds model to
determine the interest rate in short-run?


Where people make decisions about holding their wealth as
money and bonds
Because economy behaves differently in short-run than it does
in long-run
In long run, we view interest rate as determined in market
for loanable funds

Where household saving is lent to businesses and government

Where wealth holders adjust their wealth between money and
bonds, and Fed participates by controlling money supply
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In short-run, we view interest rate as determined in the
money market
Expectations and the Money Market
 Important insight of money market analysis in this
chapter
 Inverse relationship between a bond’s price and
interest rate it earns for its holder
 Therefore, if people expect interest rate to fall, they
must be expecting price of bonds to rise
 Will affect money market
 A general expectation that interest rates will rise
(bond prices will fall) in the future
 Will cause money demand curve to shift rightward in
the present
 When public as a whole expects interest rate to rise
(fall) in the future, they will drive up (down) interest
rate in the present
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Figure 9: Interest Rate
Expectations
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Using the Theory: The Fed and the
Recession of 2001

Our most recent recession officially lasted from March to
November of 2001



Starting in January 2001—three months before the official
start of the recession—Fed began to worry


What did policy makers do to try to prevent the recession, and
to deal with it once it started?
Why did consumption spending behave abnormally, rising as
income fell, and preventing recession from becoming a more
serious downtown?
Investment spending had already decreased for two quarters
in a row
Fed decided to take action

Beginning in January, Fed began increasing M1 rapidly


Federal funds rate is interest rate banks with excess reserves
charge for lending reserves to other banks
Federal funds rate fell continually and dramatically during the
year, from 6.4% down to 1.75%
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Using the Theory: The Fed and the
Recession of 2001
 While Fed’s policy was able to completely avoid the
recession
 It no doubt saved economy from a more severe and
longer-lasting one
 Fed’s policy also helps us understand the other
question we raised about the 2001 recession
 Continued rise in consumption spending throughout
the period
 Lower interest rates stimulate consumption spending
on consumer durables
 Why wasn’t Fed able to prevent recession entirely?
 Couldn’t Fed have reduced interest rate even more
rapidly?
 There are, in general, good reasons for Fed to be
cautious in reducing interest rates
 By historical standards, decrease in 2001 was quite
dramatic
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 Most economists—despite recession of 2001—give Fed
Figure 10:
The Fed in Action—2001
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