Demand and supply of money The supply of money and the equilibrium interest rate The monetary...
-
date post
19-Dec-2015 -
Category
Documents
-
view
236 -
download
4
Transcript of Demand and supply of money The supply of money and the equilibrium interest rate The monetary...
Monetary Theory and Policy
•Demand and supply of money•The supply of money and the equilibrium interest rate•The monetary transmission mechanism•The Quantity theory of money•The record of monetary policy
The money marketEarlier we said that the interest rate (i) influences aggregate spending—
specifically investment and consumption. However, we have yet to develop a theory of the interest
rate
The interest rate is governed by the demand and supply of money.
Why do agents hold money?
1. To make planned expenditures/payments
2. To be prepared for unexpected expenditures/payments.
3. To store wealth.
The interest rate ( i) measuresthe opportunity cost of
holding money
The higher the interest rate, the more interest I give up by
holding my wealth in money-- as opposed to an
interest-bearing asset.
5
Inte
rest
rate
0 Quantity of money
Dm
The money demand, Dm, slopes downward. As the interest rate falls, other things constant, so does the opportunity cost of holding money; the quantity of money demanded increases.
Demand for money
The supply of moneyWe assume that the Fed (or
central banks generally) determines the supply of
money
7
Effect of an increase in the money supply
Dm
Because the money supply is determined by the Federal Reserve, it can be represented by a vertical line.
0 Quantity of moneyM M’
SmS’m
b
a
Inte
rest
rate
i
i’
At point a, the intersection of the money supply, Sm, and the money demand, Dm, determines the market interest rate, i.Following an increase in the money supply to S’m, the quantity of money supplied exceeds the quantity demanded at the original interest rate, i.
People attempt to exchange money for bonds or other financial assets. In doing so, they push down the interest rate to i’, where quantity demanded equals quantity supplied. This new equilibrium occurs at point b.
8
Effects of an increase in the money supply on interest rates, investment, and aggregate demand
An increase in the money supply drives the interest rate down to i'.
Dm
0 MoneyM M’
Sm S’m
b
a
Inte
rest
rate
i
i’
(a) Supply and demand for money
DI
0Investment
I I’
Inte
rest
rate
i
i’
(b) Demand for investment
With the cost of borrowing lower, the amount invested increases from I to I‘.
This sets off the spending multiplier process, so the aggregate output demanded at price level P increases from Y to Y ‘
AD
0 Real GDPY Y’
Pric
e le
vel
P
(c) Aggregate demand
AD’b
ab
a
The transmission mechanism
Fed open market purchase injects reserves into the banking system
Commercial banks, thrifts, etc. expand loans and deposits
The money supply increases
The equilibrium interest rate decreases
Consumption and investment increase
Real GDP, employment, and (perhaps ) the price level increase
11
Expansionary monetary policy to correct a contractionary gap
Pric
e le
vel
125
130
AD
SRAS130
a
Potential outputLRAS
At a, the economy is producing less than its potential in the short run, resulting in a contractionary gap of $0.2 trillion.
Real GDP (trillions of dollars)
0 14.013.8
AD’
b
If the Federal Reserve increases the money supply by just the right amount, the aggregate demand curve shifts rightward from AD to AD’. A short-run and long-run equilibrium is established at b, with the pride level at 130 and output at the potential level of $14.0 trillion
Contractionary gap
The FOMC sets a target for the “federal funds” rate, which is the rate that banks
charge other banks for “borrowed” reserves.
13
Recent ups and downs in the federal funds rate
Since the early 1990s, the Fed has pursued monetary policy primarily through changes in the federal funds rate, the rate that banks charge one another for borrowing and lending excess reserves overnight.
Global financialcrisis promptsrate cuts
Rate cuts to combat recession
Rate increased to slow red-hot economy
Rate cuts to limit impact of mortgage defaults on economy
Rate increase to head off inflation
The Equation of Exchange
YPVM Where
•M is the quantity of money
•V is the velocity of circulation
•P is the price level
•Y is real GDP
What is velocity (V)?
MYPV )(
Velocity (V) is the average number of times per year a unit of money is spent for new goods and services. Let
(P Y) is nominal GDP. Let P = 1.25; Y = $8 trillion; and M= $2 trillion. Thus:
trillion $2 trillion)8$25.1( V
Or, V = 5
Money and Aggregate Demand in LR
• Velocity depends on– Customs and convention of commerce
• Innovations facilitate exchange• Higher velocity
– Frequency • The more often workers get paid
– Higher velocity
– Stability (store of value)• The better store of value
– Lower velocity
17
Equation of Exchange is Always True
The equation simply states that what is spent for new goods
and services (M V) is equal to the market value of new goods and services produced (P Y).
Illustration
trillion$105 trillion2$ VM
trillion$10 trillion$825.1$ YP
Using the numbers on a preceding slide, we can see that
and
trillion$10 YPVM
thus
“Monetarist” interpretation of the equation of exchange
“Inflation is always and everywhere a monetary phenomenon.”
The monetarists believe that price level changes (hence inflation) can be explained by changes in
quantity of money
Example
Assume that V = 5 and is constant. Y is $8 trillion
(also assumed to be constant). Initially, let M =
$2 trillion
YVMP )(
1.25 trillion8$)5 trillion 2($ P
1.50 trillion8$)5 trillion 4.2($ P
percent 20 trillion $2100 trillion)$2 - trillion 4.2($
percent 20 1.251001.25) - 5.1(
Our basic equation can be rearranged as follows:
Now solve for the price level (P):
Now let the money supply increase to $2.4 trillion. Notice that:
Thus we have:
Notice that:
Hence a 20 percent increase in the money supply causes the price level to increase by 20
percent. Monetarists put the blame for inflation
squarely at the doorstep of the monetary authorities
(in the U.S., the FED).
24
In the long run, an increase in the money supply results in a higher price level, or inflation
Pric
e le
vel
130
140
AD
Potential outputLRAS
Real GDP (trillions of dollars)
0 14.0
AD’
b
The quantity theory of money predicts that if velocity is stable, then an increase in the supply of money in the long run results in a higher price level, or inflation. Because the long-run aggregate supply curve is fixed, increases in the money supply affect only the price level, not real output.a
25
M1 velocity fluctuated so much during the 1980s that M1 growth was abandonedas a short-run policy target.
(a) Velocity of M1
The velocity of M1
26
M2 velocity appears more stable than M1 velocity, but both are now considered by the Fed as too unpredictable for short-run policy use.
(b) Velocity of M2
The velocity of M2
• A decade of annual inflation and money growth in 85 countries (average annual percent)
30
Record indicates that nations with high rates of monetary growth also suffer high rates of inflation
31
Targeting interest rate vs. targeting the money supply
An increase in the price level or in real GDP, with velocity stable, shifts rightward the money demand curve from Dm to D'm.
Dm
0 Quantity of moneyM M’
Sm S’m
e
Inte
rest
rate i’
i
D’m
e’’
e’If the Federal Reserve holds the money supply at Sm, the interest rate rises from i (at point e) to i ' (at point e').
Alternatively, the Fed could hold the interest rate constant by increasing the supply of money to S'm. The Fed may choose any point along the money demand curve D'm.
The Fed pulled on the string big time beginning in 1979—it was an anti-inflation strategy under Chairman
Paul Volcker
8
10
12
14
16
18
20
79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01
Federal Funds
Recessions are shaded
6
8
10
12
14
16
18
20
80 82 84 86 88 90 92
Mortgage Interest Rates
Recessions are shaded
Conventional 30 year
www.economagic.com
Mortgage rate
Monthly Payment1
8% $807.14
10% $965.33
12% $1,131.47
14% $1,303.36
16% $1,479.23
1 Does not include prorated insurance or property taxes.
Monthly payments on a $110,000 30 year mortgage note
400
800
1200
1600
2000
2400
80 82 84 86 88 90 92
Monthly Housing Starts
Recessions are shadedData in thousands of units
www.economagic.gov
More recently, the Fed raised the federal funds rate six times between May 1999
and May 2000—from 4.75% to 6.5 %.
Evidently unemployment was getting “too low.”
The FOMC reversed course in July 2000 and cut the
funds rate 17 times, to a low of 1.00 percent in July 2003.