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Monetary Theory and Policy

Chapter 30

© 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 transactionsThe 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 lowMovements along the curve reflect the impact of changes in the interest rate on the quantity of money demandedAssumed constant along the curve are the price level and real GDPIf 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

0 Quantity of money

i

Sm

M

Dm

i'

M'

S‘mThe intersection of the demand for

money, Dm with the supply of money,

Sm determines the equilibrium

interest rate, iIf the FED increases the money supply, the Sm curve shifts to the right and the quantity supplied exceeds the quantity demanded at interest rate iPeople now hold more of their wealth as money than they would like, so they exchange some for other financial assets, such as bondsAs 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

Inte

rest

rat

e a

b

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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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Contractionary gap

Exhibit 4: Expansionary Monetary Policy to Correct a Contractionary Gap

125

Potential output

0 11.8 12.0 Real GDP (trillions of dollars)

SRAS130

AD

a

130 b

AD'

If the economy is producing at point a where the AD curve intersects SRAS130, we havea short-run equilibrium output of $11.8 trillion and a price level of 125Actual price level is below the expected price level of 130, and equilibrium level of output is below the economy’s potential: a contractionary gapThe Fed can use monetary policy to stimulate investment, thus increasing aggregate demand to AD', attempting to move the economy to point b

Pri

ce le

vel

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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:

M x V = P x Y 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 ExchangeThe 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

Inte

rest

rat

e

0

i

Sm

Dm

e

M Quantity of money

e'

D'm

i'

The money market is in equilibrium at point eSuppose 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

M'

S'm

e"