Money and Stabilization Policy
KW Chapter 31
Velocity
• Define the ratio of transactions to the supply
of money as ‘Velocity’, the speed with which
money circulates.
• The value of transactions is nominal GDP.
• The inverse of velocity is the willingness to
hold money between transactions.
Nominal GDP
1
Velocity 
 Money 
Price Y
Money
Velocity
Equation of Exchange
• We can rewrite the definition of velocity as
Money Velocity  Nominal GDP  Price  Y
• Quantity Theory of Money says that
velocity is constant.
Keynes Insight
• Demand for liquidity is determined by the
interest rate.
– If the interest rate is high
• the opportunity cost of holding low interest paying
money is high.
• People will give up the convenience of money and hold
less liquidity
– If the interest rate is low,
• the opportunity cost of holding low interest paying
money is high
• People will hold more liquidity and enjoy more liquid
transactions.
Velocity in HK
8
6
.18
4
.17
2
.16
0
.15
.14
1999
2000
2001
VELOCITY
2002
2003
2004
2005
HK INTEREST RATE
Velocity is
an
increasing
function of
the
interest
rate.
Real Balances
• Real balances are the level of money
adjusted for inflation.
• Can be calculated as real GDP divided by
velocity
Money  Velocity  Nominal GDP  Price  Y

Money 
1

Y
Price  Velocity 
Real Money Demand
Q: Why does the real
money demand curve
slope down?
A: The greater is the
interest rate, the
greater is the
opportunity cost of
holding money.
Q: What shifts the real
money demand curve?
A: An increase in constant
price GDP will increase
the need for money for
real money transactions.
This will shift the demand
curve out. A reduction in
GDP will shift the demand
curve in.
Money Market
Money Demand
Money Supply
r
r*
M
P
Equilibrium in the Money Market
• If interest rates are too high, excess supply of
money:
– people will want to buy interest paying assets like
bank accounts or treasury bills.
– Bond dealers and banks can reduce the interest rates
they are willing to offer
• If interest rates are too low, excess demand for
money:
– people will want to sell interest paying assets like bank
accounts or treasury bills to get more liquidity.
– Bond dealers and banks must raise interest rates.
Monetary Policy
• In the US (and Euroland and Japan and
most OECD economies), the central bank
sets monetary policy by picking a short-run
interest rate they would like to prevail.
• In HK, the central bank sets monetary
policy by picking a fixed exchange rate.
Channel of Monetary Policy
• When the central bank increases the monetary base, the
money supply will increase.
• Banks have excess liquidity which they use to make
more loans.
• The supply of liquidity will exceed demand and banks
must compete to attract borrowers who will hold this
liquidity only at a lower interest rate.
• OECD central banks use their control over the supply
of money to set a certain interest rate in the money
market.
Operating Targets: Target Interest
Rates
• Most big country CB’s target interbank interest
rates, the rate at which banks lend reserves to one
another (in HK, this is called what?)
Fed
Federal Funds Rate
BoJ
Uncollateralized Call Money Rate
ECB
Main Refinancing Rate
BoK
Overnight Call Rate
UK
Official Bank Rate
Monetary Expansion:
Cut in Target Interest Rate
Money Supply
Money Supply'
r
r*
1
r**
2
Money
Demand
M
P
Monetary Contraction:
Rise in Target Interest Rate
Money Supply'
Money Supply
r
r**
r*
2
1
Money
Demand
M
P
Target Rates Affect Money Market
Rates
Money Market Rates USA
7
6
5
4
3
2
1
C.P. Rate
CEIC Database
Fed Funds
T-Bill 3 Mo
Mar-06
Sep-05
Mar-05
Sep-04
Mar-04
Sep-03
Mar-03
Sep-02
Mar-02
Sep-01
Mar-01
Sep-00
Mar-00
Sep-99
Mar-99
Sep-98
Mar-98
Sep-97
0
Dynamics of Monetary Transmission
• Money supply expansion reduces interest
rates
• Lower interest rates implies an increase in
borrowing and affects demand for interest
sensitive goods.
– Corporate Investment
– Residential Housing
• Aggregate demand shifts out. Given fixed
input prices this increase in demand stimulates
output.
Demand Driven Recession
w/ Counter-cyclical fiscal policy
YP
P
2
P*
1. Economy in
a recession.
Fed detects
deflationary
pressure
SRAS
2. Monetary
Policy Cuts
Interest Rate
1
AD′
Y*
Recessionary Gap
AD
Y
3. Investment
increases
spending to
shift the AD
curve back
to long run
equilibrium
Expansionary Monetary Policy
1. Increasing I,
increases
demand
P
ΔI
AD
ΔC
2. Multiplier effect
means this has
an additional
impact on
consumption.
AD′
Y
Demand Driven Expansion
w/ Counter-cyclical monetary policy
YP
P
2. Monetary
Policy
Raises
Interest Rate
SRAS
1
P*
2
AD
AD′
Inflationary Gap
1. Economy in
expansion.
Fed detects
inflationary
pressure
Y
3. Investment
decreases
spending to
shift the AD
curve back
to long run
equilibrium
U.S. Central bank cuts interest rates
during recessions
Lags, Mistakes and Monetary
Shocks
• It is often said that there are long and variable
lags in the monetary transmission mechanism in
that it might take several quarters for the strongest
effects of monetary policy on demand to appear
plus it is difficult to predict how long exactly it
will take for monetary policy to have its intended
effects.
• What happens if a monetary expansion
destabilizes the economy?
An Expansionary Cycle Driven by
monetary policy
2. Monetary
Policy Cuts
Interest Rate
YP
P
3
1. Economy at
LT YP.
SRAS
3. Investment
rises. The
AD curve
shfits out.
2
P*
1
AD′
AD
Inflationary Gap
Y
4. Tight labor
markets.
SRAS
returns to
long run
equilibrium
An Expansionary Cycle Driven by
monetary policy
Money
Demand
Money Supply Money Supply'
1. Increase in
money supply
pushes down
interest rates
r
3
r*
1
r**
2
2. Rising price
level reduces
real money
balances
increasing
rates.
M
P
Zero Lower Bound on Interest Rates
• Nominal interest rates cannot go below zero
– no one will lend money at an interest rate
below that of money itself.
• In Japan, central bank increased money
supply to get the economy out of a
recession. Pushed the interest rate to zero.
• Once the zero lower bound was reached
monetary policy has no effect.
Money Market at ZIRP
Money Demand
Money Supply
r
r*
r** 0
1
2
3
M
P
Japan and the ZIRP
4
3
2
1
.24
0
.22
.20
.18
.16
94 95 96 97 98 99 00 01 02 03 04 05
Velocity
Interest Rate
US Interest Rates & HK Money Market
• Under HK’s monetary policy of a fixed
exchange rate, HK$ bonds are perfect substitutes
for US$ bonds
• Financial market investors will:
– buy US$/sell HK$ whenever US$ interest rates are
higher than HK$ interest rate
– Sell US$/buy HK$ whenever US$ interest rates are
lower than HK$ interest rate
In equilibrium, HK$ money supply will adjust to
keep HK$ interest rate fixed at US$ rate.
• When the interest rate is relatively high in HK,
– demand for HK$ in forex market puts pressure on
exchange rate,
– banks will cash in US$ to buy more HK$ from HKMA
– HKMA must increase the money supply.
• When the interest rate is relatively low in
– demand for US$ in forex market puts pressure on
exchange rate,
– banks will cash in HK$ to buy more US$ from HKMA
– HKMA must increase the money supply.
Money Demand Shifts Out- Money Supply
Follows
Money Supply
Money Demand
r
2
rUS$
1
Money
Demand′
M
P
Money Demand Shifts In - Money Supply
Follows
Money Supply
Money
Demand′
r
1
rUS$
2
Money Demand
M
P
US Raises Target Rate, Money Demand Declines,
Supply Follows
Money
Demand′
r
Money Supply
2
rUS$
rUS$
1
Money Demand
M
P
Students should be able to:
• Discuss the determinants of velocity and money
demand. Calculate the effects of a change in the
interest rate.
• Describe the short-term impact of a countercyclical change in monetary policy using graphs
and words.
• Describe the long-term and short-term impact of a
monetary policy shock using graphs and words.
• Describe the impact of US monetary policy on
HK’s monetary policy.