What would be the effect on the demand for money curve L of an increase in nominal GDP?

Chapter 15 Monetary Theory and Policy

Monetary policy is the Fed.�s role in supplying money to the economy to influence aggregate economic performance.

Monetary theory is the study of the effect of money on the economy.

Economists believe that a change in the money supply affects the economy through two channels:

1.     Indirect channel � Changes in the money supply affect AD through changes in the interest rate.

2.     Direct channel � Changes in the money supply directly affect how much people want to spend.

I.                  Money and the Economy: The Indirect Channel

Demand for Money � The relationship between how much money people want to hold and the interest rate

Money here is a stock variable. We are not talking about people demanding more income (flow variable). The demand for income is represented by how much labor and other resources people are willing to sell. People demand money to carry out market transactions. The demand for money is represented by the desire of people to hold money rather than other assets that could earn more interest.

A.   The Demand for Money

Money allows people to carry out their economic transactions more easily.

-         The greater the value of transactions people want to make in a given period, the greater the demand for money. (level of real output)

-         The higher the price level, the greater the demand for money.

People can store their purchasing power in two ways:

1.     money

2.     other financial assets (bonds, stocks, etc�)

Money is liquid, but it earns no interest. (If a checkable deposit earns interest, it is generally lower than other assets.) The interest forgone is the opportunity cost of holding money.

B.   Money Demand and Interest Rates

When the market rate of interest is low, the cost of holding money is low.

When the market rate of interest is high, the cost of holding money is high.

The quantity of money demanded varies inversely with the market rate of interest.

Demand for Money (price level and real GDP constant)

Graph pg. 318 Exhibit 1

Price Level �� Demand for money �� Demand curve for money shifts to the right

GDP �� Demand for money � � Demand curve for money shifts to the right

C.   Supply of Money and the Equilibrium Interest Rate

The stock of money in the economy at a given time is determined primarily by the Fed. The supply of money is depicted as a vertical straight line (independent of the interest rate).

The intersection of the supply of money and the demand for money determines the equilibrium rate of interest.

Graph pg. 319 Exhibit 2

If the Fed increases the money supply, the money supply curve shifts to the right.

-         At the original interest rate, demand for money is less than the supply. More money is out there to hold, but people are not willing to hold it at the current rate of interest.

-         People exchange money for other assets. As they try to exchange money for assets the interest rate falls on those assets because issuers can pay less interest and still attract buyers.

-         As the interest rate decreases, people are willing to hold more money.

-         The interest rate falls until quantity demanded just equals the quantity supplied.

For a given demand for money curve, increases in the supply of money drive down the market interest rate, and decreases in the supply of money drive up the market interest rate.

II.               Money and Aggregate Demand

Monetary policy influences the money supply, which influences the market interest rate, which affects the level of planned investment, which is a component of aggregate demand.

A.   Interest Rates and Planned Investment

Example: The Fed thinks the economy is operating below its potential output. They decide to increase the money supply to stimulate output and employment.

They can expand the money supply by 1. Purchasing U.S. government bonds, 2. Lowering the discount rate, or 3. Lowering the reserve requirement.

Graph: pg. 321 Exhibit 3

a.      Supply and Demand for Money

b.     Demand for investment

c.     Aggregate Expenditure

d.     Aggregate demand

Summary of events:

M�� i �� I �� AE �� AD �

If the Fed increases interest rates:

M�� i �� I � � AE �� AD �

As long as the interest rate is sensitive to changes in the money supply, and as long as the quantity of investment is sensitive to changes in the interest rate, changes in the supply of money affect planned investment.

B.   Adding Aggregate Supply

For a given shift in the AD curve, the steeper the short-run aggregate supply curve, the smaller the increase in real GDP and the larger the increase in the price level.

The indirect effect of an increase in the money supply is to reduce the market interest rate, resulting in an increase in planned investment and a consequent increase in aggregate demand. As long as the short-run aggregate supply curve slopes upward, the short-run effect of an increase in the money supply is an increase in both real output and the price level.

Graph: pg. 323 Exhibit 4

C.   Fiscal Policy with Money

If the government increases government purchases to stimulate AD (leading to both greater output and higher prices in the short run), the increase in real output and the price level increase the demand for money.

For a given money supply, an increase in the demand for money leads to higher interest rates. Higher interest rates reduce investment spending. The reduction in investment dampens the effects of the increase in AD.

The inclusion of money in the fiscal framework introduces another reason why the simple spending multiplier overstates the increase in real output arising from any given fiscal stimulus.

III.           Money and the Economy: The Direct Channel

Another view of the effect of money sees a more direct relationship between money supply and AD.

In this view, people hold their money in financial assets and REAL ASSETS (real estate, cars, etc�). IF the money supply increases, at the original interest rate, the supply of money exceeds the amount demanded. People are holding more of their wealth in money than they want to, so they increase their demand for financial assets and REAL ASSETS. The increased demand for REAL ASSETS, increases AD.

A.   The Equation of Exchange

Equation of Exchange � The quantity of money, M, multiplied by its velocity, V, equals nominal GDP, which is the product of the Price level, P, and real GDP, Y.

M X V = P X Y

P � price level

Y � real output

V � Velocity of Money - the average number of times per year a dollar is used to purchase final goods and resources

M � quantity of money in the economy

The quantity of money in circulation, M, multiplied by the number of times the money turns over, V, is equal to the average price level times the total output.

** Every transaction involves a swap between a seller and a buyer.

Total spending = Total Receipts

B.   Quantity Theory of Money

Monetarists emphasize the direct relationship between money and AD, and claim that V is relatively stable (or predictable and not related to money supply)

Quantity Theory of Money � If the velocity of money is stable or at least predictable, then changes in the money supply have predictable effects on nominal GDP.

P X Y = M X V

If M is increased by 10%, and V is constant, P X Y must increase by 10%.

M �� spending �� higher nominal GDP

In the short run, changes in nominal GDP are divided between changes in real GDP and changes in the price level.

In the long run, increases in the money supply result only in higher prices.

Money �� Inflation

C.   What Determines the Velocity of Money?

1.     Customs and Conventions of Commerce: The velocity of money has increases over time as a variety of commercial innovations have facilitated exchange. (charge accounts, credit cards, ATMs, debit cards)

2.     Frequency with which workers get paid. More frequent � greater velocity

3.     The better money serves as a store of value, the more people hold and the less the velocity.

4.     Inflation increases, velocity increases.

D.   How Stable is Velocity

-         Between 1973 and 1979, velocity grew each year at a rate between 3-4.3 percent. Late 1970s were a high point for monetarists.

-         After 1979, the velocity of M1 became more erratic.

-         Velocity of M1 has continued to be unpredictable in the 1990s.� The equation of exchange is less reliable.

-         In 1987, the Fed switched to velocity of M2 in setting objectives for monetary growth.

-         In 1993, the Fed announced that monetary aggregates are not reliable guides for monetary policy.

IV.            Money Supply v. Interest Rate Targets

Indirect channel � Monetary authorities should worry about interest rates when considering monetary policy.

Monetarists � Monetary authorities should focus on the money supply.

The Fed lacks the tools to do both at the same time.

A.   Contrasting Policies (Example)

B.   Targets until 1982

WWII � October 1979, the Fed attempted to stabilize interest rates.

Milton Friedman, monetarist, argued that focusing on interest rates contributed to instability.

Debate raged through the 1970s.

October 1979, the Fed announced they would stop targeting interest rates and focus on targeting the growth of monetary aggregates. Interest rates became more volatile, and some economists believed that a sharp reduction in the money supply caused the recession of 1982. The Fed, under pressure, announced they would focus on interest rates and the money supply.

C.   Targets after 1982

Measurement of the money supply had become more difficult.

The relationship between M1 and economic activity had begun to break down.

Alan Greenspan said that changes in the money supply were not closely enough linked to nominal income to justify focusing only on the money supply. The Fed.�s focus has become short-term interest rates (in particular the federal funds rate.)

The Fed now tracks a variety of indicators of inflationary pressure (growth in real GDP and the unemployment rate), and target short-term interest rates.

What happens to money demand when nominal GDP increases?

How does GDP affect the demand for money?

What would cause the money demand curve to shift to the left?

What affects the money demand curve?