C h a p t e r
11
Key Concepts
The Demand for Money
Four factors influence the demand for money:
♦ The price level — An increase in the price level increases the nominal demand for money.
♦ The interest rate — An increase in the interest rate
raises the opportunity cost of holding money and
decreases the quantity of real money demanded.
♦ Real GDP — An increase in real GDP increases the
demand for money.
♦ Financial innovation — Innovations that lower the
cost of switching between money and other assets
decrease the demand for money.
Figure 11.1 shows the demand for money curve (MD).
The real quantity of money equals the nominal quantity divided by the price level. Changes in the interest
rate create movements along the demand curve;
changes in the other relevant factors change the demand and shift the demand curve.
Interest Rate Determination
An interest rate is the percentage yield on a financial
security; other variables being the same, the higher the
price of the security, the lower is the interest rate.
The interest rate is determined by the equilibrium in
the market for money, as illustrated in Figure 11.2.
The real supply of money is $3.0 trillion, so the supply
curve of money is MS. The demand curve for money is
MD, and the equilibrium interest rate is 5 percent.
♦ If the Fed increases the quantity of money, the
supply of money curve shifts rightward and the
equilibrium interest rate falls. If the Fed decreases
the quantity of money, the supply of money curve
shifts leftward and the equilibrium interest rate rises.
* This is Chapter 27 in Economics.
163
MONEY, INTEREST,
REAL GDP, AND
THE PRICE LEVEL*
164
CHAPTER 11 (27)
Short-Run Effects of Money on Real GDP
and the Price Level
The Fed’s actions ripple through the economy. Higher
interest rates:
♦ Decrease investment and consumption expenditure
♦ Increase the foreign exchange price of the dollar,
which then decreases net exports
♦ A multiplier process then occurs
Real GDP growth and the inflation rate both slow
when the Fed raises the interest rate. The opposite effects occur when the Fed lowers the interest rate. These
effects are how the Fed influences the economy.
The macroeconomic short run is a period during which
some money prices are sticky and real GDP might be
below, above, or at potential GDP.
If real GDP exceeds potential GDP so there is an inflationary gap, the Fed tightens to avoid inflation. The
Fed decreases the quantity of money, which raises the
interest rate. The higher interest rate decreases interestsensitive components of aggregate expenditure, such as
investment. The decrease in investment leads to a multiplier effect that decreases aggregate demand, thereby
lowering the price level and decreasing real GDP so it
equals potential GDP. If the Fed eases to avoid a recession, the reverse results occur.
Long-Run Effects of Money on Real GDP
and the Price Level
The macroeconomic long run is a period that is sufficiently long for the forces that move real GDP toward
potential GDP to have had their full effects.
♦ Suppose the economy is at its long-run equilibrium
and the Fed increases the quantity of money. Aggregate demand increases and the AD curve shifts
rightward, as illustrated in Figure 11.3. The price
level rises, and real GDP increases.
♦ An inflationary gap exists and the unemployment
rate is below than the natural rate. The tight labor
market leads to a rise in the money wage rate. The
short-run aggregate supply decreases, and the shortrun aggregate supply curve shifts from SAS0 to
SAS1. This situation is illustrated in Figure 11.4,
wherein real GDP returns to potential real GDP
($10 trillion) and the price level rises still higher to
130.
The quantity theory of money holds that, in the long
run, an increase in the quantity of money brings an
equal percentage increase in the price level.
The velocity of circulation is the average number of
times a dollar of money is used in a year to buy goods
and services in GDP. In terms of a formula, velocity of
circulation, V, is given by V = PY/M, where P is the
price level, Y is real GDP, and M is the quantity of
money. M1 velocity has increased and fluctuated but
M2 velocity has been quite stable.
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
The equation of exchange shows that the quantity of
money multiplied by velocity equals (nominal) GDP,
or
MV = PY.
The quantity theory makes two assumptions:
♦ Velocity is not affected by the quantity of money.
♦ Potential GDP is not affected by the quantity of
money.
With these assumptions, the equation of exchange
∆P ∆M
=
, which means that the percentshows that
P
M
age increase in the price level (the inflation rate) equals
the percentage increase in the quantity of money.
The AS/AD model also predicts that, in the long run,
an increase in the quantity of money causes the same
percentage increase in the price level. However, the
one-to-one relationship does not hold in the short run.
Historical evidence from the United States and international evidence both show that in the long run, the
money growth rate and inflation rate are positively
related and that the year-to-year relationship is weaker.
165
Questions
True/False and Explain
The Demand for Money
11. The price level is the opportunity cost of holding
money.
12. An increase in real GDP increases the demand for
money.
Interest Rate Determination
13. If the Fed buys government securities, it lowers the
interest rate.
14. If both the supply and demand for money increase,
the interest rate definitely rises.
Short-Run Effects of Money on Real GDP and the
Price Level
15. Higher interest rates affect consumption expenditure, investment, and net exports.
16. To fight inflation, the Fed will decrease the quantity of money.
Helpful Hints
17. An increase in the quantity of money increases
aggregate demand.
1. USE OF THE QUANTITY THEORY : Analysts often
use the quantity theory to help shape their thinking
about the future inflation rate by using the rate of
growth of the quantity of money to help predict
whether the inflation rate is likely to rise or fall.
Even though the relationship between the growth
rate of the quantity of money and the inflation rate
might not be one-to-one as suggested by the quantity theory, nonetheless the correlation between
higher monetary growth rates and higher inflation
rates is quite substantial.
You, too, can use this relationship to help predict
the inflation rate. For instance, if you note that the
growth rate of the quantity of money has jumped
sharply higher, you should expect higher inflation
rates to occur. Because interest rates tend to increase with the inflation rate, you would want to
obtain loans with fixed (nominal) interest rates as
quickly as possible. Conversely, you would not
want to enter into long-term savings contracts with
fixed interest rates.
18. In the short run, an increase in the quantity of
money decreases short-run aggregate supply.
Long-Run Effects of Money on Real GDP and the
Price Level
19. If the economy is at potential GDP, in the short
run an increase in the quantity of money lowers the
unemployment rate so it is less than the natural
rate.
10. In the long run, an increase in the quantity of
money decreases short-run aggregate supply.
11. Velocity equals MY/P.
12. Since 1960, M2 velocity has increased more rapidly
than M1 velocity has.
13. The quantity theory of money predicts that inflation is caused by rapidly growing velocity.
14. Almost surely, high inflation rates cause high
monetary growth rates.
166
Multiple Choice
The Demand for Money
11. An increase in ____ decreases the quantity of money
people want to hold.
a. the price level
b. real GDP
c. the interest rate
d. the quantity of money
12. Which of the following does NOT directly shift the
demand for money curve?
a. A change in GDP.
b. A change in the quantity of money.
c. Financial innovation.
d. None of the above because they all directly shift
the demand for money curve.
13. Since 1970, in the United States the demand curve
for M2 money has shifted
a. rightward in all but 2 years.
b. leftward in all but 2 years.
c. rightward in most years until 1989 and then
leftward in a few years and rightward in most.
d. leftward in most years until 1989 and then
rightward in some years and leftward in others.
Interest Rate Determination
14. If the price of an asset rises and the amount paid on
the asset does not change, what happens to the interest rate on the asset?
a. It rises
b. It does not change
c. It falls
d. The premise of the question is wrong because
changes in the price of an asset have nothing to
do with the interest rate paid on the asset.
15. If the interest rate exceeds the equilibrium interest
rate, then people ____ bonds and the interest rate
____.
a. buy; rises
b. buy; falls
c. sell; rises
d. sell; falls
CHAPTER 11 (27)
16. Taken by itself, an increase in the quantity of money
a. raises the interest rate.
b. does not change the interest rate.
c. lowers the interest rate.
d. perhaps raises or perhaps lowers the interest rate,
depending on whether the demand curve for
money has a negative or a positive slope.
17. If real GDP increases, the demand for money curve
shifts
a. leftward and the interest rate rises.
b. leftward and the interest rate falls.
c. rightward and the interest rate rises.
d. rightward and the interest rate falls.
Short-Run Effects of Money on Real GDP and the
Price Level
18. If the Fed increases the interest rate, then
a. investment and consumption expenditure decrease.
b. the price of the dollar rises on the foreign exchange market and so net exports decrease.
c. a multiplier process that affects aggregate demand occurs.
d. All of the above answers are correct.
19. In order to combat inflation, the Fed will ____ the
quantity of money and ____ the interest rate.
a. increase; raise
b. increase; lower
c. decrease; raise
d. decrease; lower.
10. To eliminate an inflationary gap, the Fed will ____
the quantity of money and ____ aggregate demand.
a. increase; increase
b. increase; decrease
c. decrease; increase
d. decrease; decrease
11. The Fed’s actions to fight a recession shift the
a. aggregate demand curve rightward.
b. aggregate demand curve leftward.
c. short-run aggregate supply curve rightward.
d. short-run aggregate supply curve leftward.
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
12. In the short run, an increase in the quantity of
money shifts the
a. AD curve rightward.
b. SAS curve rightward.
c. LAS curve rightward.
d. The answer is none of the above because an increase in the quantity of money does not shift
the AD, SAS, or LAS curves.
13. In the short run, an increase in the quantity of
money ____ the price level and ____ real GDP.
a. raises; increases
b. raises; does not change
c. raises; decreases
d. does not change; increases
Long-Run Effects of Money on Real GDP and the
Price Level
14. In the long run, an increase in the quantity of
money
a. shifts the AD curve leftward.
b. shifts the SAS curve rightward.
c. shifts the SAS curve leftward.
d. does not shift the AD curve.
167
18. Velocity equals
a. YM/P.
b. PM/Y.
c. PY/M.
d. M/PY.
19. Nominal GDP, PY, is $6 trillion. The quantity of
money is $2 trillion. Velocity is
a. 6 trillion.
b. 12.
c. 3.
d. 2.
20. Historical evidence shows that higher monetary
growth rates are associated with
a. higher inflation rates.
b. no change in the inflation rate.
c. lower inflation rates.
d. higher growth rates of real GDP.
Short Answer Problems
15. In the long run, an increase in the quantity of
money ____ the price level and ____ real GDP.
a. raises; increases
b. raises; does not change
c. raises; decreases
d. does not change; increases
16. The quantity theory of money is the idea that
a. the quantity of money is determined by banks.
b. the quantity of money serves as a good indicator
of how well money functions as a store of value.
c. the quantity of money determines real GDP.
d. in the long run, an increase in the quantity of
money causes an equal percentage increase in the
price level.
17. The equation of exchange is
a. MV = PY.
b. MP = VY.
c. MY = PV.
d. M/Y = PV.
1. Initially, the market for money is in equilibrium, as
illustrated in Figure 11.5. Then, the Fed increases
the quantity of money by $100 billion.
a. Draw this increase in Figure 11.5.
b. What was the initial equilibrium interest rate?
What happens to the equilibrium interest rate?
c. Explain, in general, the adjustment process to
the new equilibrium interest rate.
168
CHAPTER 11 (27)
TABLE 11.1
TABLE 11.2
The Demand For Money
Quantity Theory
Interest rate
(percent per year)
Quantity of
money demanded
(billions of dollars)
3
$600
____
6
1.00
$6
4
500
$500
6
____
3
5
400
550
6
____
3
6
300
605
6
____
3
2. Table 11.1 gives data on the demand for money.
a. Suppose that the equilibrium interest rate is 6
percent. What is the quantity of money?
b. Suppose that the Fed wants to lower the interest
rate to 4 percent. By how much must it change
the quantity of money? Is the open market operation is necessary to lower the interest rate an
open market purchase or sale of government securities?
Money, M
(billions of
dollars)
Velocity,
V
Real GDP, Y
Price level, (trillions of
P
dollars)
4. a. Complete Table 11.2.
b. Between the second and third rows of Table
11.2, what is the percentage increase in the
quantity of money? What is the inflation rate?
c. Between the third and fourth rows of Table
11.2, what is the percentage increase in the
quantity of money? What is the inflation rate?
d. Comment on your answers to parts (b) and (c).
You’re the Teacher
1. Your friend is talking: “When the Fed increases the
quantity of money, it usually does so by an open
market operation and buys government securities.
In fact, the Fed buys a lot of government securities,
and these securities all pay interest to the Fed. The
Fed pays for them by printing Federal Reserve
notes and increasing banks’ reserves. But neither
Federal Reserve notes nor banks’ reserves pay any
interest. So the Fed gets a lot of interest income
and has no interest expense. It seems to me that
this would be very profitable. Is it? And, if it is,
what does the Fed do with the profit?” These are
interesting questions; perhaps your friend thinks
that the Fed spends its profits on the “mother of all
parties” and would like to be invited. Tell your
friend to forget about the party by explaining the
profits and what happens to them.
3. In Figure 11.6 show how an increase in the quantity of money affects the price level and quantity of
real GDP in the short run and the long run. Label
the short-run equilibrium point a and the long-run
equilibrium point b.
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
Answers
169
Multiple Choice Answers
The Demand for Money
True/False Answers
The Demand for Money
11. F The interest rate is the opportunity cost of holding money.
12. T An increase in real GDP means more transactions occur and increases the demand for
money.
Interest Rate Determination
13. T When the Fed buys government securities, the
quantity of money increases and the interest rate
falls.
14. F If the increase in the demand for money is larger
than the increase in the supply, the interest rate
rises. But if the increase in the supply exceeds
the increase in demand, the interest rate falls.
Short-Run Effects of Money on Real GDP and the
Price Level
15. T Higher interest rates ripple through the economy, affecting many sectors.
16. T By decreasing the quantity of money, aggregate
demand decreases which lowers the price level.
17. T Changing aggregate demand is part of the ripple
effect of monetary policy.
18. F In the short run, short-run aggregate supply does
not change.
Long-Run Effects of Money on Real GDP and the
Price Level
19. T In the short run, an increase in quantity of
money increases real GDP and lowers the unemployment rate.
10. T In the long run, an increase in the quantity of
money raises money wage rates and decreases
short-run aggregate supply.
11. F Velocity equals PY/M.
12. F Since 1963, M2 velocity has not changed much,
while M1 velocity has increased and fluctuated.
13. F The quantity theory predicts that inflation is
caused by growth in the quantity of money.
14. F Almost surely, the reverse is true: High monetary growth rates cause high inflation rates.
11. c The interest rate is the opportunity cost of holding money, so an increase in the interest rate reduces the quantity of money demanded.
12. b Changes in the quantity of money create movements along the demand for money curve; they
do not shift the curve.
13. c Until about 1989, growth in real GDP generally
increased the demand for M2. Since 1989, innovation has decreased the demand for M2
while GDP growth has increased it.
Interest Rate Determination
14. c There is an inverse relationship between the
price of an asset and the interest rate paid on the
asset.
15. b When the interest rate exceeds the equilibrium
interest, there is an excess supply of money. People use the excess supply to buy bonds, thereby
driving the interest rate lower.
16. c An increase in the quantity of money creates a
surplus of money at the initial interest rate and,
as people buy financial assets to be rid of the
surplus, the price of financial assets rises, which
drives down their interest rates.
17. c An increase in GDP increases the demand for
money and, as the demand curve shifts rightward, the equilibrium interest rate rises.
Short-Run Effects of Money on Real GDP and the
Price Level
18. d Each of the answers describes one of the ripples
from the Fed’s policy.
19. c By decreasing the quantity of money and raising
the interest rate, the Fed decreases aggregate demand.
10. d An inflationary gap means that real GDP exceeds potential GDP, so decreasing the quantity
of money decreases aggregate demand and real
GDP.
11. a By shifting the aggregate demand curve rightward, the Fed increases real GDP, thereby offsetting the recession.
12. a An increase in the quantity of money increases
aggregate demand, thereby shifting the AD curve
rightward.
170
CHAPTER 11 (27)
13. a The AD curve shifts rightward so in the short
run the economy moves along an (upward sloping) SAS curve to a higher price level and increased real GDP.
Long-Run Effects of Money on Real GDP and the
Price Level
14. c In the long run, the tight labor market leads to a
rise in the money wage rate so the SAS curve
shifts leftward.
15. b In the long run, the AD curve shifts rightward
and the economy moves along its (vertical) LAS
curve, so the price level rises but real GDP does
not change.
16. d The quantity theory traces the cause of inflation
to monetary growth.
17. a This answer is the definition of the equation of
exchange.
18. c The equation of exchange, MV = PY, can be
rearranged to show that velocity equals PY/M.
19. c The answer to this question can be calculated
using the formula in the previous question. Intuitively, velocity equals the number of times an
average dollar is spent on goods and services in
GDP.
20. a Historical evidence supports the general thrust
of the quantity theory.
Answers to Short Answer Problems
1. a. Figure 11.7 shows the $100 billion increase in
the quantity of money as the rightward shift
from MS0 to MS1.
b. The initial interest rate was 6 percent; after the
increase in the quantity of money, the equilibrium interest rate fell, to 4 percent.
c. An increase in the quantity of money means
that, at the initial interest rate (6 percent), the
quantity of money supplied is greater than the
quantity of money demanded. Money holders
want to reduce their money holdings and do so
by buying financial assets, such as bonds. The
increase in the demand for financial assets raises
the price of financial assets and thereby lowers
their interest rate. As the interest rate falls, the
quantity of money demanded increases, which
reduces the excess supply of money. This process
continues until the interest rate has fallen sufficiently so that the quantity of money demanded
is the same as the quantity of money supplied.
The interest rate that sets the new quantity of
money supplied equal to the quantity of money
demanded is the (new) equilibrium interest rate.
2. a. When the interest rate is 6 percent, the quantity
of money demanded is $300 billion. Hence the
quantity supplied also must be $300 billion.
b. In order to reduce the interest rate to 4 percent,
the Fed must increase the quantity of money
supplied to $500 billion. So the quantity of
money must increase by $200 billion. In order
to increase the quantity of money, the Fed must
purchase government securities.
3. Figure 11.8 (on the next page) shows the short-run
and long-run impacts of an increase in the quantity
of money. The increase in the quantity of money
shifts the AD curve rightward. In the short run, the
money wage rate does not change and the economy
moves along SAS0 to the new equilibrium point a.
The price level rises (to P1 from P0) and real GDP
increases (to GDP1 from GDP0). However, as time
passes, the money wage rate starts to rise. This
change shifts the SAS curve leftward until eventually
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
171
M= PY/V so that M equals $1,000 billion ($1
trillion). For the following rows, the equation of
exchange was rearranged to show that MV/Y =
P.
b. Going from the second to the third row, the
quantity of money grows by 10 percent, and
(with constant velocity and real GDP) the price
level grows by 10 percent, that is, the inflation
rate is 10 percent.
c. Moving from the third to the fourth row shows
that another 10 percent increase in the quantity
of money results in another 10 percent growth
in the price level.
d. The last three rows illustrate the quantity theory
of money conclusion: A 10 percent increase in
the quantity of money raises the price level by
10 percent.
You’re the Teacher
the economy reaches its long-run equilibrium at
point b. In the long run, the price level is (much)
higher than initially (to P2 versus P0), and the level
of real GDP has returned to the initial level, potential GDP, which is equal to GDP0.
TABLE 11.3
Quantity Theory
Money, M
(billions of
dollars)
Velocity,
V
Real GDP, Y
Price level, (trillions of
P
dollars)
$1000
6
1.00
$6
500
6
1.00
3
550
6
1.10
3
605
6
1.21
3
4. a. Table 11.3 completes Table 11.2. All the answers were calculated with the equation of exchange, MV = PY. For the first row, to calculate
M, the equation of exchange was rearranged as
1. “This is a couple of great questions. Here are a couple of great answers! Sure, the Fed makes a lot of
‘profit’ and for exactly the reasons you stated: It
earns a lot of interest income on its government securities and it pays no interest expense. But the Fed
doesn’t do anything wild and crazy with its profit:
There’s not a party to die for. Instead, the Fed pays
its costs with its revenue. However, the amount of
revenue easily covers those costs, so what happens to
the extra? The Fed gives it back to the Treasury.
That’s right, the Fed sends the extra profit back to
the U.S. Treasury so the Treasury can use it as revenue to help pay for the government’s expenditures.”