MONEY, INTEREST, REAL GDP, AND
THE PRICE LEVEL
• The demand for money
• Fed influences over interest rates
• Effect of Fed actions on AD, real GDP, and
the price level in the short run & long run
• Quantity theory of money.
The Demand for Money
• The Determinants of Money Demand
– The quantity of money that people plan to
hold depends on four main factors
– The price level
– The interest rate
– Real incomes (Real GDP)
– Financial innovation
The Demand for Money
• The price level
– A rise in the price level
• increases the nominal quantity of money
demanded
• doesn’t change the real quantity of money that
people plan to hold.
– 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.
The Demand for Money
• The interest rate
– 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.
• Real GDP
– An increase in real GDP increases the volume
of expenditure, which increases the quantity
of real money that people plan to hold.
The Demand for Money
• Financial innovation
– That lowers the cost of switching between
money and interest-bearing assets decreases
the quantity of money that people plan to
hold.
The Demand for Money
• The Demand for Money Curve
– Shows 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.
The Demand for Money
– The demand
for money
curve slopes
downward
The Demand for Money
• Shifts in the Demand for Money Curve
– Real GDP
– Financial innovation
Interest Rate Determination
– An interest rate is the percentage yield on a
financial security such as a bond or a loan.
– 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.
The Bond Market.
• Bond features
• Maturity date is the specific future date on which
the maturity value will be paid to the bond
holder.
– Bond maturity dates when issued generally
range from 3 months up to 30 years.
• Coupon rate
– Between the date of issuance and the
maturity date, annual interest payment equals
the coupon rate times the maturity value.
The Bond Market.
• Yield to maturity
• the effective interest rate that the bond-holder
earns if the bond is held to maturity.
• Bond price
• If P=maturity value, bond sells at “par”.
• If P>maturity value, bond sells above “par”.
• Example:
– Bond that matures 20 years from today with a
maturity value of $1000 and a coupon rate of
10% will pay:
– $100 per year for 20 years
– $1000 at maturity
– The bond could be sold at any point in time for
a price above or below its maturity value.
The Bond Market.
• Computing yields on one year bonds
• coupon rate = cr, maturity value =mv,
price = P
• Yield = (MV+cr(MV))/P -1 = MV(1+cr)/P -1
– As P rises, yield (interest rate) falls.
– If P=MV (par), yield=cr
– If P>MV (above par), yield<cr
• What is the yield on a one year bond
that has a maturity value of 1000 and
coupon rate of 8% if price equals
–
$900
$950
$1050
The Bond Market.
• Computing yields on Zero Coupon Bonds.
• No interest payments are made between the
sale of the bond and its maturity.
• yield = (MV/P)1/T – 1
• If you buy a zero coupon bond today for
$1000 and it has a maturity value of $1500 in
10 years
– yield = (1500/1000)1/10 -1 = .0414 = 4.14%
• As the price paid for a bond increases, the yield
(interest rate) falls.
The Bond Market.
• Determinants of bond yields
– Risk
• Debt rating agencies:
» Moody’s & Standard and Poors
» AAA=superior quality
» C=imminent default
• Inflation risk.
– Term
• Longer term bonds have greater inflation
and default risk.
The Bond Market.
• Yield curve
– Shows relationship between yield and term on
government bonds
– Slope of yield curve reflects
• Expectations of future short term interest rates
• Greater risk of long term bonds
– If short term interest rates are expected to be constant
in the future, yield curve will slope upward reflecting
risk premia for longer term bonds.
– A steepening of the yield curve suggests that financial
markets believe short term interest rates will be rising
in the future.
• The dynamic yield curve
• The bond market
Interest Rate Determination
• Money Market Equilibrium
– The Fed determines the quantity of money
supplied and on any given day, that quantity is
fixed.
– The supply of money curve is vertical at the
given quantity of money supplied.
– Money market equilibrium determines the
interest rate.
Interest Rate Determination
Interest Rate Determination
– If the Fed
increases the
money supply,
interest rates will
fall.
– As money supply
increases, banks
have more
loanable funds,
interest rates are
reduced.
– Fed has better
control over short
term than long
Short-Run Effects of Money on
Real GDP, and the Price Level
•
Ripple Effects of Monetary Policy
– If the Fed increases the interest rate, three
events follow:
1. Investment and consumption expenditures
decrease.
2. The value of the $ rises and net exports
decrease.
3. A multiplier process unfolds.
Short-Run Effects of Money on
Real GDP, and the Price Level
– The Fed tightens the money supply to reduce
inflationary pressure. Real GDP decreases
and the price level falls.
Short-Run Effects of Money on
Real GDP, and the Price Level
– Effects of an Increase in the money supply to
recover from recession.
Short-Run Effects of Money on
Real GDP, and the Price Level
• Limitations of Monetary Stabilization Policy
– The impact depends on the sensitivity of
expenditure plans to the interest rate.
– The effects of monetary policy can take a
long time be realized.
– These effects are variable and hard to predict.
LR Effects of Money on Real GDP and the Price Level
• An increase in the
money supply will
increase AD.
• SR Effects:
– Real wage falls
– Unemployment
falls
– Real GDP
increases.
– Price level
rises.
LR Effects of Money on Real GDP and the Price Level
• Movement to new
LR equilibrium
– the money wage rate
rises
– SAS decreases.
– RGDP decreases
– P rises
• Compared to
original LR equil.
– No change in RGDP,
unempl, real wage
– Higher prices, nominal
GDP & nominal wage
Quantity Theory of Money
– Equation of exchange
– MV = Py
– M=money supply
– V=velocity of money
– P=price level
– y=real GDP
Quantity Theory of Money
– MV = PY
– Q-theory assumes that velocity and potential
GDP are not affected by the quantity of
money.
– P = (MV/Y)
– Because (V/Y) does not change when M
changes, a change in M brings a
proportionate change in P.
Quantity Theory of Money
Quantity Theory of Money
– P = (V/Y)M
– Divide this equation by
– P = (V/Y)M
– and the term (V/Y) cancels to give
– P/P = M/M
– P/P is the inflation rate
– M/M is the growth rate of the quantity of
money.
Quantity Theory of Money
• Historical Evidence on the Quantity Theory
of Money
– U.S. money growth and inflation are correlated
– more so in the long run than the short run
– broadly consistent with the quantity theory.
Quantity Theory of Money
Quantity Theory of Money
Decade averages show stronger relationship
Quantity Theory of Money
• International Evidence