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The Demand For Money

Don’t people always want as much money as possible? Yes

But when we speak about demand for something, we don’t mean amount people would desire if they could have all they wanted Without having to sacrifice anything for it Demand for money does not mean how much money

people would like to have in best of all worlds Rather, it means how much money people would like

to hold, given constraints they face

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An Individual’s Demand for Money

At any given moment, total amount of wealth we have is given If we want to hold more wealth in form of money, we must hold

less wealth in other forms (which are those?) These two facts determine an individual’s wealth constraint An individual’s quantity of money demanded

Amount of wealth individual chooses to hold as money Rather than as other assets

Why do people want to hold some of their wealth in form of money? Money is a means of payments- other forms of wealth are not

used for purchase But the other forms of wealth provide a financial return to their

owners Money pays either very little interest (where?) or none at all

When you hold money, you bear an opportunity cost Interest you could have earned by holding other assets instead

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An Individual’s Demand for Money Individuals choose how to divide wealth between two assets

Money, which can be used as a means of payment but earns no interest

Bonds, which earn interest, but cannot be used as a means of payment

What determines how much money an individual will decide to hold? While tastes vary from person to person, three key variables

have rather predictable impacts on most of us Price level Real income Interest rate – opportunity cost of money?

When we add up everybody’s behavior, we find a noticeable and stable tendency for people to hold less money when it is more expensive to hold money that is when the interest rate is higher

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The Demand for Money by Businesses

Some money is held by businesses Stores keep some currency in their cash registers Firms generally keep funds in business checking

accounts They have only so much wealth, and they

must decide how much of it to hold as money rather than other assets

They want to hold more money when real income or price level is higher Less money when opportunity cost (interest rate) is

higher

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The Economy-Wide Demand For Money

Just as each person and each firm in economy has only so much wealth There is a given amount of wealth in the economy as a

whole at any given time Total wealth must be held in one of two forms

Money or bonds Economy-wide quantity of money demanded

Amount of total wealth all households and businesses, together, choose to hold as money rather than as bonds

Demand for money depends on the same three variables that we discussed for individuals A rise in the price level will increase demand for money A rise in real income (real GDP) will increase demand for

money A rise in interest rate will decrease demand for money

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The Money Demand Curve Figure 1 shows a money demand curve

Tells us total quantity of money demanded in economy at each interest rate

Curve is downward sloping As long as other influences on money

demand don’t change A drop in interest rate—which lowers the

opportunity cost of holding money—will increase quantity of money demanded

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Figure 1: The Money Demand Curve

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Shifts in the Money Demand Curve

What happens when something other than interest rate changes quantity of money demanded? Curve shifts

A change in interest rate moves us along money demand curve

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Figure 2: A Shift in the Money Supply Curve

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Figure 3: Shifts and Movements Along the Money Demand Curve—A Summary

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The Supply of Money

Just as for money demand, we would like to draw a curve showing quantity of money supplied at each interest rate Interest rate can rise or fall, but money supply will remain

constant unless and until Fed decides to change it Suppose Fed, for whatever reason, were to change money

supply Would be a new vertical line

Showing a different quantity of money supplied at each interest rate

Open market purchases of bonds inject reserves into banking system Shift money supply curve rightward by a multiple of reserve

injection Open market sales have the opposite effect

Withdraw reserves from system Shift money supply curve leftward by a multiple of reserve

withdrawal

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Figure 4: The Supply of Money

700

M 2s

Money ($ Billions)

Interest Rate

6%E

J

500

3%

M 1s

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Equilibrium in the Money Market Key Step #3

Combines what you’ve learned about money demand and money supply to find equilibrium interest rate in economy

We are interested in how interest rate is determined in short-run

In short-run we look for the equilibrium interest rate in money market Interest rate at which quantity of money demanded

and quantity of money supplied are equal Important to understand what equilibrium in money

market actually means Remember that money supply curve tells us quantity

of money that actually exists in economy Determined by Fed

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Equilibrium in the Money Market

Money demand curve tells us how much money people want to hold at each interest rate

Equilibrium in money market occurs when quantity of money people are actually holding (quantity supplied) is equal to quantity of money they want to hold (quantity demanded)

Can we have faith that interest rate will reach its equilibrium value in money market? Yes

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Figure 5: Money Market Equilibrium

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How the Money Market Reaches Equilibrium

If people want to hold less money than they are currently holding, then, by definition They must want to hold more in bonds than they are

currently holding An excess demand for bonds

When there is an excess supply of money in economy There is also an excess demand for bonds

Can illustrate steps in our analysis so far as follows

Conclude that, when interest rate is higher than its equilibrium value, price of bonds will rise

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An Important Detour: Bond Prices and Interest Rates A bond, in the simplest terms, is a promise to pay back

borrowed funds at a certain date or dates in the future When a large corporation or government wants to

borrow money, it issues a new bond and sells it in the marketplace Amount borrowed is equal to price of bond

The higher the price, the lower the interest rate General principle applies to virtually all types of bonds

When price of bonds rises, interest rate falls When price of bonds falls, interest rate rises

Relationship between bond prices and interest rates helps explain why government, press, and public are so concerned about the bond market Where bonds issued in previous periods are bought

and sold

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Back to the Money Market Complete sequence of events

Can also do the same analysis from the other direction Would be an excess demand of money, and an excess

supply of bonds In this case, the following would happen

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What Happens When Things Change?

Focus on two questions What causes equilibrium interest rate to

change? What are consequences of a change in

the interest rate? Fed can change interest rate as a

matter of policy, or Interest rate can change on its own

As a by-product of other events

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How the Fed Changes the Interest Rate

Changes in interest rate from day-to-day, or week-to-week, are often caused by Fed Fed officials cannot just declare that interest rate should be lower

Fed must change the equilibrium interest rate in the money market Does this by changing money supply

The process works like this

Fed can raise interest rate as well, through open market sales of bonds Setting off the following sequence of events

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How the Fed Changes the Interest Rate

If Fed increases (decreases) money supply by buying (selling) government bonds, the interest rate falls (rises)

By controlling money supply through purchases and sales of bonds, Fed can also control the interest rate

What is the effect of this change in the economy?

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Figure 6: An Increase in the Money Supply

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How Do Interest Rate Changes Affect the Economy?

If Fed increases money supply through open market purchases of bonds Interest rate will fall

How is the macroeconomy affected? A drop in the interest rate will boost

several different types of spending in the economy

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How the Interest Rate Affects Spending Lower interest rate stimulates business

spending on plant and equipment Remember that the interest rate is one of the key

costs of any investment project A firm deciding whether to spend on plant and

equipment compares benefits of project—increase in future income—with costs of project

Interest rate changes also affect spending on new houses and apartments that are built by developers or individuals Loan agreement for housing is called a mortgage

Mortgage interest rates tend to rise and fall with other interest rates

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How the Interest Rate Affects Spending Interest rate affects consumption spending on big

ticket items Such as new cars, furniture, and dishwashers Economists call these consumer durables because

they usually last several years Can summarize impact of money supply changes as

follows When Fed increases money supply, interest rate falls,

and spending on three categories of goods increases Plant and equipment New housing Consumer durables (especially automobiles)

When Fed decreases money supply, interest rate rises, and these categories of spending fall

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Monetary Policy and the Economy Fed—through its control of money supply—has power to influence real

GDP When Fed controls or manipulates money supply in order to achieve any

macroeconomic goal it is engaging in monetary policy To find final equilibrium in economy, would need quite a bit of information

about how sensitive spending is to drop in the interest rate As well as how changes in income feed back into money market to affect

interest rate This is what happens when Fed conducts open market purchases of bonds

Open market sales by Fed have exactly the opposite effects Equilibrium GDP would fall by a multiple of the initial decrease in spending

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Figure 7(a): Monetary Policy andthe Economy

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Figure 7(b): Monetary Policy andthe Economy

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An Increase in Government Purchases What happens when government changes its fiscal policy

Say, by increasing government purchases Increase in government purchases will set off multiplier process

Increasing GDP and income in each round Increase in government purchases, which by itself shifts the aggregate

expenditure line upward Also sets in motion forces that shift it downward

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An Increase in Government Purchases

At the same time as the increase in government purchases has a positive multiplier effect on GDP Decrease in a and I have negative multiplier effects

In short-run, increase in government purchases causes real GDP to rise But not by as much as if interest rate had not increased Aggregate expenditure line is higher, but by less than ΔG Real GDP and real income are higher

But rise is less than [1/(1 – MPC)] x ΔG Money demand curve has shifted rightward

Because real income is higher Interest rate is higher

Because money demand has increased Autonomous consumption and investment spending are

lower Because the interest rate is higher

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Figure 8(a): Fiscal Policy and theMoney Market

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Figure 8(b): Fiscal Policy and theMoney Market

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Crowding Out Once Again When effects in money market are included in short-run

macro model An increase in government purchases raises interest

rate and crowds out some private investment spending May also crowd out consumption spending

In classical, long-run model, an increase in government purchases also causes crowding out

In short-run, however, conclusion is somewhat different While we expect some crowding out from an increase in

government purchases, it is not complete Investment spending falls, and consumption spending

may fall, but together, they do not drop by as much as rise in government purchases

In short-run, real GDP rises

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Other Spending Changes Positive shocks would shift aggregate expenditure line

upward Increases in government purchases, investment, net exports,

and autonomous consumption, as well as decreases in taxes, all shift aggregate expenditure line upward Real GDP rises, but so does interest rate Rise in equilibrium GDP is smaller than if interest rate

remained constant Negative shocks shift aggregate expenditure line downward Decreases in government purchases, investment, net exports,

and autonomous consumption, as well as increases in taxes, all shift aggregate expenditure line downward Real GDP falls, but so does interest rate Decline in equilibrium GDP is smaller than if interest rate

remained constant

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What About the Fed? In our analysis of spending shocks, we’ve

made an implicit but important assumption Assumed Fed does not change money supply in

response to shifts in aggregate expenditure line While this assumption has helped us focus

on the impact of spending shocks It is not the way Fed has conducted policy during

past few decades Has used monetary policy to prevent spending

shocks from changing GDP at all

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Are There Two Theories of the Interest Rate? In classical model, interest rate is determined in market for

loanable funds In this chapter you learned that interest rate is determined in money

market Where people make decisions about holding their wealth as money

and bonds Which theory is correct?

Both Why don’t we use classical loanable funds model to determine

the interest rate in short-run? Because economy behaves differently in short-run than it does in

long-run In long run, we view interest rate as determined in market for

loanable funds Where household saving is lent to businesses and government

In short-run, we view interest rate as determined in the money market Where wealth holders adjust their wealth between money and bonds,

and Fed participates by controlling money supply

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Expectations and the Money Market Important insight of money market analysis in this

chapter Inverse relationship between a bond’s price and

interest rate it earns for its holder Therefore, if people expect interest rate to fall, they

must be expecting price of bonds to rise Will affect money market

A general expectation that interest rates will rise (bond prices will fall) in the future Will cause money demand curve to shift rightward in

the present When public as a whole expects interest rate to rise

(fall) in the future, they will drive up (down) interest rate in the present

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Figure 9: Interest Rate Expectations

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Using the Theory: The Fed and the Recession of 2001 Our most recent recession officially lasted from March to

November of 2001 What did policy makers do to try to prevent the recession, and

to deal with it once it started? Why did consumption spending behave abnormally, rising as

income fell, and preventing recession from becoming a more serious downtown?

Starting in January 2001—three months before the official start of the recession—Fed began to worry Investment spending had already decreased for two quarters in

a row Fed decided to take action

Beginning in January, Fed began increasing M1 rapidly Federal funds rate is interest rate banks with excess reserves

charge for lending reserves to other banks Federal funds rate fell continually and dramatically during the

year, from 6.4% down to 1.75%

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Using the Theory: The Fed and the Recession of 2001 While Fed’s policy was able to completely avoid the

recession It no doubt saved economy from a more severe and longer-

lasting one Fed’s policy also helps us understand the other question we

raised about the 2001 recession Continued rise in consumption spending throughout the

period Lower interest rates stimulate consumption spending on

consumer durables Why wasn’t Fed able to prevent recession entirely?

Couldn’t Fed have reduced interest rate even more rapidly? There are, in general, good reasons for Fed to be cautious in

reducing interest rates By historical standards, decrease in 2001 was quite dramatic

Most economists—despite recession of 2001—give Fed high marks for its actions during that year

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Figure 10: The Fed in Action—2001