Principles of Macroeconomics Dr. S. Ghosh Spring 2005

Chpt 11: Money, Interest Rate, Price Level and Real GDP Learning Goals: • How the money market works • How equilibrium interest rates are determined • How the Fed can change the quantity of money and affect the real GDP and price level in the short-run I. The Demand for Money A. The Influences on Money Holding 1. Four factors influence the quantity of money that people plan to hold: the price level, the interest rate, real GDP, and financial innovation. 2. A rise in the price level increases the nominal quantity of money but doesn’t change the real quantity of money that people plan to hold. a) Nominal money is the amount of money measured in dollars. b) The quantity of nominal money demanded is proportional to the price level — a 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent. 3. The interest rate is the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset. A rise in the interest rate decreases the quantity of money that people plan to hold. 4. An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold. 5. Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of money that people plan to hold.

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Principles of Macroeconomics Dr. S. Ghosh Spring 2005

B. The Demand for Money Curve 1. The demand for money curve is the relationship between the quantity of real money demanded, M/P, and the interest rate when all other influences on the amount of money that people wish to hold remain the same. Graph of the Demand for Money curve:

2. The demand for money curve slopes downward—a rise in the interest rate raises the opportunity cost of holding money and brings a decrease in the quantity of money demanded, which is shown by a movement up along the demand for money curve. C. Shifts in the Demand for Money Curve 1. The demand for money changes and the demand for money curve shifts if real GDP changes or if financial innovation occurs.

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Principles of Macroeconomics Dr. S. Ghosh Spring 2005

Example: Suppose there is an increase in real GDP. How does the demand for money curve shift? Reasoning?

2. A decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward.

D. The Demand for Money in the United States Figure 11.3 shows scatter diagrams of the interest rate against real M1 and real M2 from 1970 through 2003 and interprets the data in terms of movements along and shifts in the demand for money curves.

II. Interest Rate Determination A. An interest rate is the percentage yield on a financial security such as a bond or a stock. 1. The price of a bond and the interest rate are inversely related. If the price of a bond falls, the interest rate on the bond rises. If the price of a bond rises, the interest rate on the bond falls. 2. We can study the forces that determine the interest rate in the market for money.

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Principles of Macroeconomics Dr. S. Ghosh Spring 2005

B. Money Market Equilibrium 1. The Fed determines the quantity of money supplied and on any given day, that quantity is fixed. The real quantity of money supplied is equal to the nominal quantity supplied divided by the price level. 2. The supply of money curve is vertical at the given quantity of money supplied. 3. Money market equilibrium determines the interest rate. Graph of the Money Market

4. If the interest rate is above the equilibrium interest rate, the quantity of money that people are willing to hold is less than the quantity supplied. They try to get rid of their “excess” money by buying financial assets. This action raises the price of these assets and lowers the interest rate.

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Principles of Macroeconomics Dr. S. Ghosh Spring 2005

5. If the interest rate is below the equilibrium interest rate, the quantity of money that people want to hold exceeds the quantity supplied. They try to get more money by selling financial assets. This action lowers the price of these assets and raises the interest rate. 6. Only at the equilibrium interest rate do we have the quantity of money demanded by people equal to the quantity of money supplied. There is no reason for the interest rates to change in equilibrium. C. Changing the Interest Rate 1. When the Fed changes the quantity of money, the interest rate changes. Example: Suppose the Fed sells government bonds in the open market. What is the impact on the equilibrium interest rates? Why?

2. If the Fed conducts an open market sale of securities, the quantity of money decreases, the money supply curve shifts leftward, and the interest rate rises. Page 5 of 13

Principles of Macroeconomics Dr. S. Ghosh Spring 2005

3. If the Fed conducts an open market purchase of securities, the quantity of money increases, the money supply curve shifts rightward, and the interest rate falls. 4. Question: Can changes in demand for money affect the equilibrium interest rate?

Example: Suppose an economy is experiencing a lot of financial innovations in the money market. Would you expect this to have an impact on the equilibrium interest rate? How?

5. In general, changes in the equilibrium interest rate can occur if there are –

Shifts in the money demand curve (due to changes in real GDP, changes in the price level or financial innovation).

–

Shifts in the money supply curve (due to changes in the reserve ratio, the discount rate or open market operations by the Fed, all of which change the quantity of money).

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Principles of Macroeconomics Dr. S. Ghosh Spring 2005

III. Short-Run Effects of Money on Real GDP and the Price Level A. Ripple Effects of the Interest Rate 1. If the Fed raises the interest rate, three events follow: a) Investment and consumption expenditures decrease, because the interest rate is the opportunity cost of funds used to finance investment and big-ticket consumer purchases. b) With interest rates in other countries unchanged, funds move into the United States, the exchange rate rises, and net exports decrease. c) These changes in the components of aggregate expenditure set off a multiplier process that magnifies the initial effects. 2. Figure 11.6 in the following page summarizes these ripple effects.

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Principles of Macroeconomics Dr. S. Ghosh Spring 2005

B. The Fed Tightens to Avoid Inflation 1. The following figures illustrate the effect of fighting inflation with monetary policy in three panels. The first shows the money market, and the second shows the aggregate supply and aggregate demand curves. (a) The Money Market

(b) Real GDP and the Price Level

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Principles of Macroeconomics Dr. S. Ghosh Spring 2005

2. A decrease in the quantity of money in part (a) raises the interest rate. The rise in the interest rate decreases expenditure which shifts the AD curve leftward in part (b). Real GDP decreases and the price level falls. C. The Fed Eases to Fight Recession 1. Similarly, the Fed can fight recession with monetary policy. (c) The Money Market

(d) Real GDP and the Price Level

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Principles of Macroeconomics Dr. S. Ghosh Spring 2005

2. An increase in the quantity of money in part (a) lowers the interest rate. The fall in the interest rate increases expenditure and shifts the AD curve rightward in part (b). Real GDP increases and the price level rises.

IV. Long-Run Effects of Money on Real GDP and the Price Level A. An Increase in the Quantity of Money at Full Employment 1. Figure 11.9 illustrates the effect of an increase in the quantity of money at full employment in two panels. The first shows the money market and the second shows the SAS, LAS, and AD curves.

2. An increase in the quantity of money in part (a) lowers the interest rate. The fall in the interest rate shifts the AD curve rightward in part (b). The inflationary gap brings a rise in the money wage rate and a leftward shift in the SAS curve. In the long run, an increase in the quantity of money leaves real GDP unchanged but raises the price level.

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Principles of Macroeconomics Dr. S. Ghosh Spring 2005

B. The Quantity Theory of Money 1. The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. 2. The quantity theory of money is based on the velocity of circulation and the equation of exchange. a) The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP. Calling the velocity of circulation V, then V = PY/M.

b)The equation of exchange states that the quantity of money, M, multiplied by the velocity of circulation, V, equals the price level, P, multiplied by real GDP, Y. That is:

MV = PY

3. The quantity theory assumes that velocity and potential GDP are not affected by the quantity of money. So

P = (V/Y)/M

3. Because (V/Y) does not change when M changes, a change in M brings a proportionate change in P. That is, the change in P, ∆P, is related to the change in M, ∆M, by the equation: ∆P = (V/Y) ∆M. Divide this last equation by the previous one and the term (V/Y) cancels to give:

∆P/P = ∆M/M. Page 11 of 13

Principles of Macroeconomics Dr. S. Ghosh Spring 2005

where ∆P/P is the inflation rate and = ∆M/M is the growth rate of the quantity of money.

C. The Quantity Theory and the AS-AD Model 1. The quantity theory of money can be interpreted in terms of the ASAD model. In the long run, real GDP equals potential GDP and according to the AS-AD model, an increase in the quantity of money brings an equal percentage rise in the price level. Graph

2. The AS-AD model also makes clear why the quantity theory is a long-run theory. In the short run, an increase in the quantity of money brings an increase in real GDP and a smaller than proportionate rise in the price level.

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Principles of Macroeconomics Dr. S. Ghosh Spring 2005

Examples: 1. If the nominal quantity of money is $200 billion and the value of aggregate output is $1 trillion, what is the velocity of circulation?

2. If nominal GDP equals $10 trillion and the velocity of circulation is 5, then what is the quantity of money?

D. Historical Evidence on the Quantity Theory of Money 1. Historical evidence shows that U.S. money growth and inflation are correlated, more so in the long run than the short run, which is broadly consistent with the quantity theory. 2. Figure 11.11 graphs money growth and inflation in the United States from 1963 to 2003. E. International Evidence on the Quantity Theory of Money 1. International evidence shows a marked tendency for high money growth rates to be associated with high inflation rates. 2. Figure 11.12 shows scatter diagrams of money growth and inflation for various countries and regions during the 1980s and 1990s. F. Correlation, Causation, and Other Influences 1. Correlation is not causation; money growth and inflation could be correlated because money growth causes inflation, or because inflation causes money growth, or because a third factor caused both. But the combination of historical, international, and other independent evidence gives us confidence that in the long run, money growth causes inflation. 2. In the short run, however, the quantity theory is not correct. To understand the short-term fluctuations in inflation, we need the ASAD model. Page 13 of 13