•Demand and supply of money
•The supply of money and the equilibrium
interest rate
•The monetary transmission mechanism
•The Quantity theory of money
•The record of monetary policy
Earlier we said that the interest rate
(i) influences aggregate spending—
specifically investment and
consumption. However, we have yet
to develop a theory of the interest
rate
The interest rate is
governed by the
demand and supply of
money.
1. To make planned
expenditures/payments
2. To be prepared for unexpected
expenditures/payments.
3. To store wealth.
The higher the interest rate,
the more interest I give up by
holding my wealth in money- as opposed to an interestbearing asset.
Interest rate
The money demand, Dm, slopes
downward. As the interest rate
falls, other things constant, so
does the opportunity cost of
holding money; the quantity of
money demanded increases.
Dm
0
Quantity of money
5
We assume that the Fed (or
central banks generally)
determines the supply of
money
Interest
rate
Effect of an increase in the money supply
Because the money supply is
determined by the Federal Reserve,
it can be represented by a vertical
line.
S’m
Sm
At point a, the intersection of the
money supply, Sm, and the money
demand, Dm, determines the market
interest rate, i.
a
i
b
i’
Dm
0
M
M’
Quantity of
money
Following an increase in the money
supply to S’m, the quantity of money
supplied exceeds the quantity
demanded at the original interest
rate, i.
People attempt to exchange money for bonds or other financial assets. In doing so,
they push down the interest rate to i’, where quantity demanded equals quantity
supplied. This new equilibrium occurs at point b.
7
i’
Sm
S’m
a
b
(b) Demand for
investment
i
a
i’
(c) Aggregate demand
Price level
i
(a) Supply and demand
for money
Interest rate
Interest rate
Effects of an increase in the money supply on
interest rates, investment, and aggregate
demand
b
P
b
a
AD’
Dm
AD
DI
0
I
I’
M
M’ Money
Investment
An increase in the money
supply drives the interest With the cost of borrowing
rate down to i'.
lower, the amount invested
increases from I to I‘.
0
0
Y
Y’
Real GDP
This sets off the spending
multiplier process, so the
aggregate output demanded at
price level P increases from Y to
8
Y‘
M↑→i↓→I↑→AD↑→Y↑
Fed open market purchase injects reserves into the
banking system
Commercial banks, thrifts, etc. expand loans and
deposits
The money supply increases
The equilibrium interest rate decreases
Consumption and investment increase
Real GDP, employment, and (perhaps ) the price level
increase
Expansionary monetary policy to correct a
contractionary gap
Price
level
Potential output
LRAS
At a, the economy is producing less
than its potential in the short run,
resulting in a contractionary gap of
$0.2 trillion.
SRAS130
b
130
a
125
AD’
If the Federal Reserve increases the
money supply by just the right
amount, the aggregate demand
curve shifts rightward from AD to
AD’. A short-run and long-run
equilibrium is established at b, with
the pride level at 130 and output at
the potential level of $14.0 trillion
AD
0
13.8
14.0
Contractionary gap
Real GDP
(trillions of dollars)
11
The FOMC sets a
target for the “federal
funds” rate, which is
the rate that banks
charge other banks for
“borrowed” reserves.
Recent ups and downs in the federal funds rate
Rate increased to slow redhot economy
Rate increase to
head off inflation
Global financial
crisis prompts
rate cuts
Rate cuts
to combat
recession
Rate cuts
to limit
impact of
mortgage
defaults on
economy
Since the early 1990s, the Fed has pursued monetary policy primarily through changes in
the federal funds rate, the rate that banks charge one another for borrowing and lending
excess reserves overnight.
13
The Equation of Exchange
M V  P Y
Where
•M is the quantity of money
•V is the velocity of circulation
•P is the price level
•Y is real GDP
What is velocity (V)?
Velocity (V) is the average number of times
per year a unit of money is spent for new goods
and services. Let
V  (P Y )  M
(P  Y) is nominal GDP. Let P = 1.25; Y = $8 trillion;
and M= $2 trillion. Thus:
V  (1.25  $8 trillion)  $2 trillion
Or, V = 5
Money and Aggregate Demand in LR
• Velocity depends on
– Customs and convention of commerce
• Innovations facilitate exchange
• Higher velocity
– Frequency
• The more often workers get paid
– Higher velocity
– Stability (store of value)
• The better store of value
– Lower velocity
17
Equation of Exchange is Always True
The equation simply states that
what is spent for new goods
and services (M  V) is equal to
the market value of new goods
and services produced (P  Y).
Illustration
Using the numbers on a preceding slide, we can see that
P Y  $1.25  $8 trillion  $10 trillion
and
M V  $2 trillion  5  $10 trillion
thus
M V  P Y  $10 trillion
“Monetarist” interpretation
of the equation of exchange
The monetarists believe
that price level changes
(hence inflation) can be
explained by changes in
quantity of money
“Inflation is always and everywhere a monetary
phenomenon.”
Example
Assume that V = 5 and is
constant. Y is $8 trillion
(also assumed to be
constant). Initially, let M =
$2 trillion
Our basic equation can be rearranged as follows:
P  (M V )  Y
Now solve for the price level (P):
P  ($2 trillion  5)  $8 trillion  1.25
Now let the money supply increase to $2.4 trillion. Notice
that:
($2.4 trillion - $2 trillion) 100  $2 trillion  20 percent
Thus we have:
P  ($2.4 trillion  5)  $8 trillion  1.50
Notice that:
(1.5 - 1.25) 100  1.25  20 percent
Hence a 20 percent
increase in the money
supply causes the price
level to increase by 20
percent. Monetarists put
the blame for inflation
squarely at the doorstep of
the monetary authorities
(in the U.S., the FED).
In the long run, an increase in the money
supply results in a higher price level, or
inflationPotential output
Price level
LRAS
140
b
130
a
The quantity theory of money
predicts that if velocity is stable, then
an increase in the supply of money in
the long run results in a higher price
level, or inflation. Because the longrun aggregate supply curve is fixed,
increases in the money supply affect
only the price level, not real output.
AD’
AD
0
14.0
Real GDP
(trillions of dollars)
24
(a) Velocity of M1
M1 velocity fluctuated so much during the 1980s that M1 growth was abandoned
as a short-run policy target.
25
(b) Velocity of M2
M2 velocity appears more stable than M1 velocity, but both are now considered by the Fed
as too unpredictable for short-run policy use.
26
German Hyperinflation and Money
Record indicates that nations with high rates of
monetary growth also suffer high rates of inflation
• A decade of annual inflation and money
growth in 85 countries (average annual
percent)
30
Targeting interest rate vs. targeting the money
supply
Interest rate
Sm
S’m
If the Federal Reserve holds the money supply
at Sm, the interest rate rises from i (at point e)
to i ' (at point e').
e’
i’
i
An increase in the price level or in real GDP,
with velocity stable, shifts rightward the money
demand curve from Dm to D'm.
e
e’’
D’m
Dm
0
M
M’
Alternatively, the Fed could hold the
interest rate constant by increasing the
supply of money to S'm. The Fed may
choose any point along the money
demand curve D'm.
Quantity of money
31
The Fed pulled on the string
big time beginning in
1979—it was an antiinflation strategy under
Chairman Paul Volcker
Modeling Contractionary Monetary Policy
Price Level
Potential
GDP
AS
AD2
AD1
0
Y1
Real GDP
20
Recessions are shaded
18
16
14
12
10
8
79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01
Federal Funds
20
Conventional 30 year
Recessions are shaded
18
16
14
12
10
8
6
80
82
84
86
88
Mortgage Interest Rates
www.economagic.com
90
92
Monthly payments on a $110,000
30 year mortgage note
Mortgage rate
Monthly
Payment1
8%
$807.14
10%
$965.33
12%
$1,131.47
14%
$1,303.36
16%
$1,479.23
1 Does
not include prorated insurance or
property taxes.
2400
Data in thousands of units
Recessions are shaded
2000
1600
1200
800
400
80
www.economagic.gov
82
84
86
88
Monthly Housing Starts
90
92
More recently, the
Fed raised the federal
funds rate six times
between May 1999
and May 2000—from
4.75% to 6.5 %.
Evidently
unemployment was
getting “too low.”
The FOMC reversed course
in July 2000 and cut the
funds rate 17 times, to a low
of 1.00 percent in July 2003.
Beginning in 2004, and until
summer of 2007, the FED
was mainly concerned
about inflation.