Chapter 14

  • December 1, 2020

Chapter 14

The Demand for Money: how much money people would like to hold, given the constraints that they face

  • Wealth constraint: The wealth at any moment is given and that you must give up one kind of wealth in order to acquire more of another
  • A household’s quantity of money demanded is the amount of wealth that the household chooses to hold as money, rather than as other assets
  • When you hold money, you bear an opportunity cost – the interest or other financial return you could have earned by holding other assets instead
  • Households choose how to divide wealth between money, which can be used as a means of payment but earns no interest and other assets, which earn interest or other financial returns, but cannot be used as a means of payment

What determines how much money each of us will decide to hold?

  • The price level: the greater the number of dollars you spend in a typical week or month, the more money you will want to have on hand to make your purchases
    • A rise in the price level will increase the amount of money you want to hold
  • Real income: If income increases, you will spend more dollars in a typical week or month, so you will want to hold more of your wealth in the form of money
  • Interest rate: The greater the interest rate, the greater the opportunity cost of holding money
    • A rise in the interest rate decreases your quantity of money demanded

Nominal versus Real Interest Rates

  • The real rate is what people care about when making decisions about spending or saving
  • Nominal interest rate is what tells us the opportunity cost of holding money

The Economy-Wide Demand for Money

  • The quantity of money demanded is the amount of total wealth in the economy that all households and businesses, together, want to hold as money rather than other assets
  • The demand for money depends on 3 variables
    • A rise in the price level will increase the demand for money
    • A rise in real income will increase the demand for money
    • A rise in nominal interest rates will decrease the quantity of money demanded

Money Demand Curve

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

Shifts in the Money Demand Curve

  • A change in the interest rate moves us along the money demand curve
  • A change in money demand caused by something other than the interest rate will cause the curve to shift

The Supply of Money

  • Money supply curve: A line showing the total quantity of money supplied in the economy at each interest rate, vertical until the Fed changes it

Equilibrium in the Money Market

  • Equilibrium interest rate: the interest rate at which the quantity of money demanded and the quantity of money supplied are equal

How the Money Market Reaches Equilibrium

  • When there is an excess supply of money in the economy, there is also an excess demand for bonds
  • Excess supply of money: The amount of money supplied exceeds the amount demanded at a particular interest rate
  • Excess demand for bonds: The amount of bonds demanded exceeds the amount supplied at a particular interest rate
  • An interest rate higher than the equilibrium causes an excess supply of money which causes an excess demand for bonds

Bond Prices and Interest Rates

  • When the price of bonds rises, the interest rate falls; when the price of bonds falls, the interest rate rises

Back to the Money Market

  • Interest rate higher than equilibrium à Excess supply of money and excess demand for bonds à Price of bonds increase à Interest rate goes down
  • Interest rate lower than equilibrium à Excess demand for money and excess supply for bonds à Price of bonds goes down à Interest rate goes up

What Happens when Things Change?

How the Fed Can Change the Interest Rate

  • Must change the equilibrium interest rate in the money market, and it does this by changing the money supply
  • To lower the interest rate, the Fed increases the money supply through open market purchases of bonds
  • Fed conducts open market purchases à Money supply goes up à Excess supply of money and excess demand for bonds à Price of bonds goes up à Interest rate goes down, injects reserves into the banking system
  • Fed conducts open market sales à Money supply goes down à Excess demand for money and excess supply for bonds à Price of bonds goes down à Interest rate goes up

How do interest rate changes affect the economy?

  • When the Fed increases the money supply, the interest rate falls, and spending on three categories of goods increases: plant and equipment, new housing, and consumer durables
  • When the Fed decreases the money supply, the interest rate rises, and these categories of spending fall

Monetary Policy

  • Control of manipulation of interest rates by the Federal Reserve designed to achieve a macroeconomic goal

How Monetary Policy Works

  • Open market purchases à Money supply goes up (money multiplier) à Interest rate goes down à a and I^p goes up à (expenditure multiplier) Real GDP goes up
  • Open market sales à Money supply goes down (money multiplier) à Interest rate goes up à a and I^p goes down à (expenditure multiplier) Real GDP goes down

Targeting the Interest Rate

  • The Fed wants to prevent unnecessary fluctuations in the interest rate in order to avoid unnecessary shifts in the AE line
  • To prevent any drop in GDP, the Fed maintains the target interest rate by increasing the money supply

Changing the Interest Rate Target

  • The Fed knows that a lower interest rate would stimulate additional investment and consumption spending, and could shift the AE line back up to its original position = must lower its interest rate target
  • To prevent or address unwanted changes in aggregate expenditure, the Fed can change its interest rate target, adjusting the money supply as needed to reach it

Monetary Policy with Many Interest Rates

The Federal Funds Rate: the interest rate charged for loans of reserves among banks

  • Federal funds market: loans in a market that it can very easily monitor and control

Unconventional Monetary Policy

  • Conventional monetary policy: the Fed tries to guide the economy by controlling the federal funds rate and interest rates, aggregate expenditure and real GDP
  • Three situations can make conventional monetary policy less effective
    • Changing interest rate spreads
    • The zero lower bound
    • Financial crises

Changing Interest Rate Spreads

  • Spread: the difference between an interest rate and some other benchmark interest rate
  • Changing the rate will do nothing about the spread
  • Spread is based off of differences in risk
  • While the Fed cannot change interest rate spreads with its conventional tool, it can change spreads by arranging the buying or selling of assets other than government bonds
  • But because of the economic and political costs, the Fed ordinarily avoids doing so

Zero Lower Bound

  • The lowest possible value for any nominal interest rate
  • Any further drop in the federal funds rate would imply a negative rate which can’t occur
  • Real interest rate = nominal interest rate – rate of inflation
  • Even when the federal funds rate hits the zero lower bound, the Fed still has unconventional tools to increase aggregate expenditure, including purchasing assets other than short-term government bonds to reduce spreads and increasing expected inflation to reduce real interest rates

Financial Crises

  • When a financial crisis looms, the Fed’s most important job is to help stabilize the financial system itself and prevent a financial collapse
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