Unit 4: Money, Banking, and Monetary Policy

1. Unit 4: Money, Banking, and Monetary Policy

2. Nominal vs. Real Interest Rates

3. Interest Rates and Inflation Lenders charge interest on loans to make up for the purchasing power they lose to inflation over the life of the loan. (And also to make a profit) Suppose you give someone a 10 year loan and the nominal interest rate on the contract is 6%. If the inflation rate turns out to be 8% over the life of a loan, how much is the REAL interest rate? Nominal – inflation = Real 6% - 8% = - 2% In reality, you get paid back an amount that has less purchasing power.

4. No, man! Don’t do it! Nominal Inflation

5. Interest Rates and Inflation Nominal Interest Rates- The “face value” interest rate written on the loan contract. The expected rate of inflation is “built in” to this number when the loan contract is written. Nominal = Real interest rate + expected inflation Real Interest Rates- The nominal interest rate adjusted for inflation. This measures the purchasing power of the interest lenders collect on loans. Real = Nominal interest rate - expected inflation

6. Nominal vs. Real Interest Rates Remember: Unanticipated/unexpected inflation HURTS lenders because they didn’t write that into their nominal interest rate on the contract. • So they’re getting paid back with money that won’t buy as much as they originally thought. Remember: Unanticipated/unexpected inflation HELPS borrowers because the money they have to pay in interest isn’t as much of a burden.

7. So far we have only been looking at NOMINAL interest rates in the Money Market because M1 money is very liquid and is spent quickly. Inflation doesn’t have time to erode the purchasing power of the money in your pocket. What about REAL interest rates?

8. Market for Loanable Funds

9. Loanable Funds Market The loanable funds market shows the demand of loans by borrowers and the supply of loanable funds by savers/lenders. • Demand- Inverse relationship between real interest rate and quantity loans demanded • Supply- Direct relationship between real interest rate and quantity loans supplied This is NOT the same as the money market. (supply is NOT vertical on this graph)

10. Loanable Funds Market At the equilibrium real interest rate the amount borrowers want to borrow equals the amount lenders want to lend. Real Interest Rate SSavers/Lenders ire DBorrowers QLoans Quantity of Loans

11. Loanable Funds Market • This market is measured by the REAL INTEREST RATE because loans are all about a longer period of time, and inflation has a chance to affect the purchasing power of the money repaid. • People make choices about whether to save/lend or borrow based on long-term outcomes.

12. Loanable Funds Market • The Demand and Supply curves on the Loanable Funds graph can shift just like all other curves. • The Demand for loanable funds comes from borrowers. - Consumers, businesses, the government, and foreigners can all be borrowers of loanable funds. • The Supply for loanable funds comes from people who save. - Since money saved in accounts is loaned out by banks.

13. Major Shifters of the Demand for Loanable Funds: • Changes in perceived business opportunities (rate of return on projects) • A change in beliefs about the rate of return on investment spending can increase or reduce the amount of desired spending at any given interest rate. • If firms believe that the economy is ripe with profitable investment opportunities, the demand for loanable funds will increase. • If firms believe the economy is poised for a recession with few profitable investment opportunities, the demand for loanable funds will decrease.

14. Major Shifters of the Demand for Loanable Funds: • 2. Changes in the government’s borrowing • Governments that run budget deficits are major sources of the demand for loanable funds. • If the amount of tax revenue is way less than gov’t spending (a budget deficit), the Treasury must borrow funds (instead of printing more money). This increases the demand for loanable funds in the market. • If the government’s tax revenue was more than its spending (a budget surplus), the government wouldn’t need to borrow, so the demand for loanable funds would decrease.

15. Loanable Funds Market Example: The Gov’t increases deficit spending Government borrows from private sector Increasing the demand for loans Real Interest Rate SSavers/Lenders Real interest rates increase causing crowding out!! r1 re D1 DBorrowers QLoans Q1 Quantity of Loans

16. Crowding Out The usual reason the gov’t engages in deficit spending is because it’s using fiscal policy to close a recessionary gap. (Gov spending ↑, Taxes ↓) But, when the gov’t has to borrow money, this increases the demand for loanable funds, which increases the real interest rate. Higher interest rates means others don’t want to borrow money to spend (like on their businesses), so C and I ↓. This makes AD↓.

17. Crowding Out So, “Crowding Out” is the idea that the gov’t does something to try to improve the economy, when actually they hurt it a little bit by increasing interest rates. Businesses (investors) and consumers are “crowded out” of the loanable funds market, or blocked from what they would have normally done when interest rates were lower. Interest Rates ↑ + 10%!

18. 2008 Audit Exam

19. 2008 Audit Exam

20. Major Shifters of the Supply for Loanable Funds: • Changes in private savings behavior • If households decide to consume more and save less, the supply of loanable funds will shift to the left. (and vice versa) • 2. Changes in foreign deposits into the country • A nation may receive more financial inflow from foreign countries in a given year. • If a nation is perceived to have a stable government, a strong economy and is a good place to save money, foreign money will flow into that nation’s financial markets, increasing the supply of loanable funds.

21. Money Supply and Interest Rates in the Short Run • In the Short Run, changes in the Money Supply DO affect the nominal and real interest rates. • In the short run: • An increase in the money supply leads to a fall in interest rates. • A decrease in the money supply leads to a rise in interest rates.

22. Money Supply and Interest Rates in the Short Run In the Short Run: An increase in the money supply leads to a fall in Nominal interest rates in the Money Market model. A fall in Nominal interest rates leads to a rise in investment spending, I, which then leads to a rise in real GDP. The rise in real GDP leads to a rise in consumer spending and also leads to a rise in savings (at each stage of the multiplier process, part of the increase in disposable income is saved). Since there is a rise in savings, there is an increase in the supply of loanable funds.

23. Money Supply and Interest Rates in the Long Run • In the Long Run, changes in the Money Supply DO NOT affect the nominal and real interest rates. • Why not?

24. Money Supply and Interest Rates in the Long Run Let’s pick up the story where we left off: In the long run, the aggregate price level will rise by the same proportion as the increase in the money supply. (Quantity Theory of Money: MV = PQ, we assume V an Q to be relatively stable, so any change in M equals a change in P). A rise in the aggregate price level increases money demand because people need more M1 money to pay for transactions that are more expensive now. The money demand curve increases, and the equilibrium interest rate rises back to its original level.

25. Money Supply and Interest Rates in the Short Run What about the loanable funds market? In the long run, real GDP falls back to its original level as wages and other nominal prices rise. As a result, the supply of loanable funds shifts back to the left. Therefore, in the long run, changes in the money supply do not affect either the Nominal or the Real interest rate.