Part I
Exploring
Monetary
Theory
“… good economic policies should be based
on sound economic theory. Hence, in order to
understand how the money supply can be
used as an instrument of economic policy, you
must first understand how changes in the
money supply affect economic activity.
Elijah M. James
Key Definitions
Monetary Theory: The study of how the
supply of, and demand for, money influences
the economy.
Money Supply: The total amount of money
available in an economy at a given point in
time. Standard measures usually include both
the currency in circulation and demand
deposits.
FAQ
What is the difference between monetary and
fiscal policy?
Monetary Policy refers to the measures taken by
the central bank to influence the economy by
regulating the amount and value of money in
circulation. (Note: Monetarists tend to put more
faith in monetary policy.)
Fiscal Policy (aka budgetary policy) refers to the
measures taken by the government to tax and
spend. (Note: Keynesian economists tend to put
more faith in fiscal policy.)
The Money Supply
(M0): The monetary base. This is the actual
currency that is in circulation. As of January 2007,
this amounts to almost $46 billion.
Canada’s Money Base
(M1): money that can be used at any time as a
means of payment; ie. M0 (currency in circulation
outside banks) plus demand deposits.
(M2): M1 plus personal savings deposits. (Savings
deposits can be easily and quickly converted into
cash, subject to a withdrawal limit.)
(M3): M2 plus term deposits. (Money that cannot be
accessed until a fixed agreed upon time.)
Weird things to note:
•  Almost half of our money base is comprised of $100.00 bills.
•  Thousand dollar bills account for almost nine times the value
of our loonies! (Yet, it hasn’t been printed since the year 2000)
Back
1
The Loanable Funds Model
Real Rate of Interest
S
This model does not look at ALL
money in an economy (which
would include the money in cash
registers, wallets, and stuffed
under mattresses).
r1
D
Q
Quantity of Loanable Funds
Loanable Funds Theory
The loanable funds model looks
ONLY at the market for loanable
funds.
This model highlights the
correlation between interest
rates and the quantity of money
available for loans.
Market for Loanable Funds
S
Real Rate of Interest
Market for Loanable Funds
Loanable funds theory suggests
that interest rates are
determined by the supply and
demand of loanable funds in the
capital markets.
• The supply of funds (S) would
be provided by savings.
r1
D
• The demand for funds (D)
would be determined by
investments.
The quantities of both S and D
will respond to interest rates
(just like in any market), and will
thus determine the equilibrium
level of interest (the “price” of
borrowed money).
Q
Quantity of Loanable Funds
This is a classical theory that highlights flexible prices as the
primary mechanism that will correct the economy. Let’s see how!
à
How Loanable Funds Will Correct the Economy
How Loanable Funds Will Correct the Economy
If the economy starts to lag,
people will buy less products
Market for Loanable Funds
Market for Loanable Funds
S2
S S and services…
2
S
r1
r2
D
Q
Quantity of Loanable Funds
D2
This will result in lower interest
rates, which will encourage more
borrowing and spending!
but they will save less!
Real Rate of Interest
Real Rate of Interest
but they will save more!
Thus, the supply of funds will
increase and the demand for
funds will decrease.
r2
r1
D2
D
Real Rate of Interest
D
Q
Quantity of Loanable Funds
Mnemonic: “Loanable funds are REAL-ly fun!”
The Money Market Model
Nominal Rate of
Interest
The Y-axis depicts the real
interest rate (the “price” for
borrowed money).
It is the “REAL” rate because
decisions regarding loaning of
funds must take inflation into
account. (We can’t very well
loan money out at 2% if inflation
is 3%!)
r1
This will result in higher interest
rates, which will discourage
borrowing and spending!
Thus, AD = C + I + G + (X-M) will decrease due to
supressed consumption and investment (both said to be
interest sensitive components of AD).
A Note About the Axis in Loanable Funds
S
The supply of funds will
decrease while demand
increases, raising interest rates!
Q
Quantity of Loanable Funds
Thus, AD = C + I + G + (X-M) will increase due to
stimulated consumption and investment (both said to be
interest sensitive components of AD).
Market for Loanable Funds
If the economy starts to
overheat, people will buy more
products and services…
The Money Market model is
based on Keynes’ “liquidity
preference” theory.
MS
Ieq
MD
Qeq
Quantity of
Money
In fact, the money demand (MD)
curve is sometimes referred to
as the liquidity preference curve
(LP).
This theory suggests that
interest rates are not determined
by the supply and demand of
loanable funds (i.e. money in
banks), but rather by the supply
of and demand for liquid cash!
2
Notice that when interest
rates are low, more
people will “hold” (aka
“hoard”) their money!
r
MD
Quantity
of Money
M1
Nominal Rate of
Interest
A Note About the Axis in the Money Market
The y-axis depicts the nominal
interest rate in the money
market model because the
money market is focused on
liquid cash for immediate use –
not specifically on loaning of
funds.
MS
Ieq
It is the “nominal” rate because
decisions regarding the use of
cash are immediate and do not
take future inflation into
account.
MD
Qeq
Quantity of
Money
In other words, an increase in
interest rates would not
increase the money supply (just
as an increase in real estate
prices would not increase the
quantity of land).
Ieq
MD
Qeq
We’d rather
hold cash than
earn low interest.
In this theory, the supply of
money (S) would be determined
simply by the money supply,
and thus would remain constant
with respect to interest rates.
MS
Quantity of
Money
The demand for funds (D) would be determined by the desire to
hold cash in liquid form. The demand is influenced by interest rates
because if interest is low, then people will be willing to forego the
low interest in order to hold their cash in liquid form. However, if
interest is high, then people will be willing to forego the ability to
hold their cash in order to earn the high interest.
Using the Money Market
Model to illustrate
changes to the Money
Supply on Interest Rates
It’s plain to see that if the
money supply increases,
then interest rates will fall.
Nominal Rate of Interest
We’d rather
earn high
interest than
hold
cash.
The Money Market Model
MS1
MS2
M1
M2
I1
I2
MD
higher MS =
lower
interest
Quantity of Money
Looking at the aggregate
model, we can see the
effect that lowered interest
rates will have on NDI.
lower
interest =
higher NDI
AE1
Lowered interest rates will
increase investment
spending, and this will add
to aggregate expenditure.
Examining the “monetarist’s” view of how to use
monetary policy to stimulate the economy
“Transmission mechanisms” in economics are just like a row of dominos!
Buying
bonds…
1 step
increases
money
supply…
which lowers
interest
rates…
2 step
which increases
borrowing,
spending, and
GDP!
3 step
AE2
AE
Nominal
Interest
Rate
Keynes believed that the
money circulating outside
of banks was the critical
issue with respect to
interest rates.
Nominal Rate of
Interest
MS
Real GDP
Illustrating the Keynesian perspective, which
suggests that we should use fiscal policy to
stimulate the economy… not monetary policy!
Buying
bonds…
1 step
increases
money
supply…
which increases
which lowers hoarding of money!
Thus decreasing
interest
both savings AND
rates…
spending! Oh no!!!
2 step
3 step
3