The Demand For Money

1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. Figure 1: The Money Demand Curve

8. 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

9. Figure 2: A Shift in the Money Supply Curve

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

11. 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

12. s M 2 Interest s M 1 Rate E 6% J 3% 700 500 Money ($ Billions) Figure 4: The Supply of Money

13. 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

14. 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

15. Figure 5: Money Market Equilibrium

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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?

22. Figure 6: An Increase in the Money Supply

23. 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

24. 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

25. 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

26. 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

27. Figure 7(a): Monetary Policy andthe Economy

28. Figure 7(b): Monetary Policy andthe Economy

29. 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

30. 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

31. Figure 8(a): Fiscal Policy and theMoney Market

32. Figure 8(b): Fiscal Policy and theMoney Market

33. 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

34. 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

35. 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

36. 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

37. 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

38. Figure 9: Interest Rate Expectations

39. 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%

40. 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

41. Figure 10: The Fed in Action—2001