Chapter Monetary Policy
Can someone please summarize the relationships between money supply, aggregate demand, aggregate supply and interest rates?. and supply of money will determine the interest rate. 2. As the money The rise in the interest rate will cause less investment, which causes aggregate demand and the level of income to But the link between money and the level of income . Aggregate Supply is the total of all final goods and services which aggregate demand curve shows the relationship between the price level This additional demand for money and credit will push interest rates even higher.
The relationship between interest rates and the quantity of money demanded is an application of the law of demand. If we think of the alternative to holding money as holding bonds, then the interest rate—or the differential between the interest rate in the bond market and the interest paid on money deposits—represents the price of holding money. As is the case with all goods and services, an increase in price reduces the quantity demanded.
Other Determinants of the Demand for Money We draw the demand curve for money to show the quantity of money people will hold at each interest rate, all other determinants of money demand unchanged. Among the most important variables that can shift the demand for money are the level of income and real GDP, the price level, expectations, transfer costs, and preferences.
That relationship suggests that money is a normal good: An increase in real GDP increases incomes throughout the economy. The demand for money in the economy is therefore likely to be greater when real GDP is greater. The Price Level The higher the price level, the more money is required to purchase a given quantity of goods and services. All other things unchanged, the higher the price level, the greater the demand for money. Expectations The speculative demand for money is based on expectations about bond prices.
All other things unchanged, if people expect bond prices to fall, they will increase their demand for money. If they expect bond prices to rise, they will reduce their demand for money. The expectation that bond prices are about to change actually causes bond prices to change. If people expect bond prices to fall, for example, they will sell their bonds, exchanging them for money. That will shift the supply curve for bonds to the right, thus lowering their price.
The importance of expectations in moving markets can lead to a self-fulfilling prophecy. Expectations about future price levels also affect the demand for money. The expectation of a higher price level means that people expect the money they are holding to fall in value. Given that expectation, they are likely to hold less of it in anticipation of a jump in prices.
Expectations about future price levels play a particularly important role during periods of hyperinflation. If prices rise very rapidly and people expect them to continue rising, people are likely to try to reduce the amount of money they hold, knowing that it will fall in value as it sits in their wallets or their bank accounts.
Toward the end of the great German hyperinflation of the early s, prices were doubling as often as three times a day. Under those circumstances, people tried not to hold money even for a few minutes—within the space of eight hours money would lose half its value! Transfer Costs For a given level of expenditures, reducing the quantity of money demanded requires more frequent transfers between nonmoney and money deposits.19. Money Supply and Interest Rates
As the cost of such transfers rises, some consumers will choose to make fewer of them. They will therefore increase the quantity of money they demand. In general, the demand for money will increase as it becomes more expensive to transfer between money and nonmoney accounts. The demand for money will fall if transfer costs decline. In recent years, transfer costs have fallen, leading to a decrease in money demand.
Preferences Preferences also play a role in determining the demand for money. Some people place a high value on having a considerable amount of money on hand. For others, this may not be important. Household attitudes toward risk are another aspect of preferences that affect money demand.
As we have seen, bonds pay higher interest rates than money deposits, but holding bonds entails a risk that bond prices might fall.
Demand, Supply, and Equilibrium in the Money Market
There is also a chance that the issuer of a bond will default, that is, will not pay the amount specified on the bond to bondholders; indeed, bond issuers may end up paying nothing at all. A money deposit, such as a savings deposit, might earn a lower yield, but it is a safe yield. Heightened concerns about risk in the last half of led many households to increase their demand for money.
Such an increase could result from a higher real GDP, a higher price level, a change in expectations, an increase in transfer costs, or a change in preferences. The reverse of any such events would reduce the quantity of money demanded at every interest rate, shifting the demand curve to the left.
The Supply of Money The supply curve of money Curve that shows the relationship between the quantity of money supplied and the market interest rate, all other determinants of supply unchanged.
We have learned that the Fed, through its open-market operations, determines the total quantity of reserves in the banking system. We shall assume that banks increase the money supply in fixed proportion to their reserves.
Because the quantity of reserves is determined by Federal Reserve policy, we draw the supply curve of money in Figure In drawing the supply curve of money as a vertical line, we are assuming the money supply does not depend on the interest rate.
Changing the quantity of reserves and hence the money supply is an example of monetary policy. The supply curve of money is a vertical line at that quantity. Equilibrium in the Market for Money The money market The interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money. Money market equilibrium The interest rate at which the quantity of money demanded is equal to the quantity of money supplied.
Relationship between money supply and aggregate demand
With a stock of money Mthe equilibrium interest rate is r. Here, equilibrium occurs at interest rate r. Effects of Changes in the Money Market A shift in money demand or supply will lead to a change in the equilibrium interest rate.
Changes in Money Demand Suppose that the money market is initially in equilibrium at r1 with supply curve S and a demand curve D1 as shown in Panel a of Figure Now suppose that there is a decrease in money demand, all other things unchanged.
A decrease in money demand could result from a decrease in the cost of transferring between money and nonmoney deposits, from a change in expectations, or from a change in preferences. In this chapter we are looking only at changes that originate in financial markets to see their impact on aggregate demand and aggregate supply. Changes in the price level and in real GDP also shift the money demand curve, but these changes are the result of changes in aggregate demand or aggregate supply and are considered in more advanced courses in macroeconomics.
Panel a shows that the money demand curve shifts to the left to D2. We can see that the interest rate will fall to r2. To see why the interest rate falls, we recall that if people want to hold less money, then they will want to hold more bonds. Thus, Panel b shows that the demand for bonds increases. The higher price of bonds means lower interest rates; lower interest rates restore equilibrium in the money market.
The fall in the interest rate will cause a rightward shift in the aggregate demand curve from AD1 to AD2, as shown in Panel c. As a result, real GDP and the price level rise. Lower interest rates in turn increase the quantity of investment. They also stimulate net exports, as lower interest rates lead to a lower exchange rate. An increase in money demand due to a change in expectations, preferences, or transactions costs that make people want to hold more money at each interest rate will have the opposite effect.
The money demand curve will shift to the right and the demand for bonds will shift to the left. The resulting higher interest rate will lead to a lower quantity of investment. Also, higher interest rates will lead to a higher exchange rate and depress net exports. Thus, the aggregate demand curve will shift to the left. All other things unchanged, real GDP and the price level will fall.
Changes in the Money Supply Now suppose the market for money is in equilibrium and the Fed changes the money supply. All other things unchanged, how will this change in the money supply affect the equilibrium interest rate and aggregate demand, real GDP, and the price level? Suppose the Fed conducts open-market operations in which it buys bonds.
This is an example of expansionary monetary policy. The impact of Fed bond purchases is illustrated in Panel a of Figure As we learned, when the Fed buys bonds, the supply of money increases.
Panel b of Figure At the original interest rate r1, people do not wish to hold the newly supplied money; they would prefer to hold nonmoney assets. To reestablish equilibrium in the money market, the interest rate must fall to increase the quantity of money demanded. The interest rate must fall to r2 to achieve equilibrium. The lower interest rate leads to an increase in investment and net exports, which shifts the aggregate demand curve from AD1 to AD2 in Panel c.
Real GDP and the price level rise. The reduction in interest rates required to restore equilibrium to the market for money after an increase in the money supply is achieved in the bond market. The increase in bond prices lowers interest rates, which will increase the quantity of money people demand.
Lower interest rates will stimulate investment and net exports, via changes in the foreign exchange market, and cause the aggregate demand curve to shift to the right, as shown in Panel cfrom AD1 to AD2.
Open-market operations in which the Fed sells bonds—that is, a contractionary monetary policy—will have the opposite effect. When the Fed sells bonds, the supply curve of bonds shifts to the right and the price of bonds falls. The bond sales lead to a reduction in the money supply, causing the money supply curve to shift to the left and raising the equilibrium interest rate.
Higher interest rates lead to a shift in the aggregate demand curve to the left. As we have seen in looking at both changes in demand for and in supply of money, the process of achieving equilibrium in the money market works in tandem with the achievement of equilibrium in the bond market. The interest rate determined by money market equilibrium is consistent with the interest rate achieved in the bond market.
Key Takeaways People hold money in order to buy goods and services transactions demandto have it available for contingencies precautionary demandand in order to avoid possible drops in the value of other assets such as bonds speculative demand.
The higher the interest rate, the lower the quantities of money demanded for transactions, for precautionary, and for speculative purposes. The lower the interest rate, the higher the quantities of money demanded for these purposes. The demand for money will change as a result of a change in real GDP, the price level, transfer costs, expectations, or preferences.
We assume that the supply of money is determined by the Fed. The supply curve for money is thus a vertical line. Money market equilibrium occurs at the interest rate at which the quantity of money demanded equals the quantity of money supplied. All other things unchanged, a shift in money demand or supply will lead to a change in the equilibrium interest rate and therefore to changes in the level of real GDP and the price level.
In the Fed was concerned about the possibility that the United States was moving into an inflationary gap, and it adopted a contractionary monetary policy as a result. Draw a four-panel graph showing this policy and its expected results. In Panel ause the model of aggregate demand and aggregate supply to illustrate an economy with an inflationary gap. In Panel cshow how it will affect the demand for and supply of money. The demand for money can be in several ways.
Transactions demand for money: If the transaction is very high then the quantity of money demanded for transaction is high too.
It is also a store of value. There are two ways in which people can store their purchasing power in the form of money in the form of other financial assets such as private and government securities Precautionary demand for money: The precautionary demand for money varies directly with nominal national income and inversely with the interest rate. Asset demand or Speculative demand for money: This kind of demand for money people wishes to hold because of its liquidity and lack of risk.
The asset demand for money varies inversely with the interest rate. Money demand for money and interest rate are inversely related The demand for money slopes downward because as interest rate declines, the opportunity cost of holding money will decline too.
Therefore, the quantity of money demanded will increase. The effects of an increase in the money supply: When the money supply increases, people will have excess money to spend and two things can happen Direct effect of an increase in the money supply: That is some people will demand more goods and services. Indirect effect of an increase in the money supply: Therefore, excess reserves will increase and banks will want to lend more.