MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL

1. MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL • The demand for money • Fed influences over interest rates • Effect of Fed actions on AD, real GDP, and the price level in the short run & long run • Quantity theory of money.

2. The Demand for Money • The Determinants of Money Demand • The quantity of money that people plan to hold depends on four main factors • The price level • The interest rate • Real incomes (Real GDP) • Financial innovation

3. The Demand for Money • The price level • A rise in the price level • increases the nominal quantity of money demanded • doesn’t change the real quantity of money that people plan to hold. • The quantity of nominal money demanded is proportional to the price level • a 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent.

4. The Demand for Money • The interest rate • the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset. • A rise in the interest rate decreases the quantity of money that people plan to hold. • Real GDP • An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.

5. The Demand for Money • Financial innovation • That lowers the cost of switching between money and interest-bearing assets decreases the quantity of money that people plan to hold.

6. The Demand for Money • The Demand for Money Curve • Shows the relationship between the quantity of real money demanded (M/P) and the interest rate when all other influences on the amount of money that people wish to hold remain the same.

7. The Demand for Money • The demand for money curve slopes downward

8. The Demand for Money • Shifts in the Demand for Money Curve • Real GDP • Financial innovation

9. Interest Rate Determination • An interest rate is the percentage yield on a financial security such as a bond or a loan. • The price of a bond and the interest rate are inversely related. • If the price of a bond falls, the interest rate on the bond rises. • If the price of a bond rises, the interest rate on the bond falls.

10. The Bond Market. • Bond features • Maturity date is the specific future date on which the maturity value will be paid to the bond holder. • Bond maturity dates when issued generally range from 3 months up to 30 years. • Coupon rate • Between the date of issuance and the maturity date, annual interest payment equals the coupon rate times the maturity value.

11. The Bond Market. • Yield to maturity • the effective interest rate that the bond-holder earns if the bond is held to maturity. • Bond price • If P=maturity value, bond sells at “par”. • If P>maturity value, bond sells above “par”. • Example: • Bond that matures 20 years from today with a maturity value of $1000 and a coupon rate of 10% will pay: • $100 per year for 20 years • $1000 at maturity • The bond could be sold at any point in time for a price above or below its maturity value.

12. The Bond Market. • Computing yields on one year bonds • coupon rate = cr, maturity value =mv, price = P • Yield = (MV+cr(MV))/P -1 = MV(1+cr)/P -1 • As P rises, yield (interest rate) falls. • If P=MV (par), yield=cr • If P>MV (above par), yield<cr • What is the yield on a one year bond that has a maturity value of 1000 and coupon rate of 8% if price equals • $900 $950 $1050 • As bond prices rise, yields (interest rates) fall.

13. The Bond Market. • Computing yields on Zero Coupon Bonds. • No interest payments are made between the sale of the bond and its maturity. • yield = (MV/P)1/T – 1 • If you buy a zero coupon bond today for $1000 and it has a maturity value of $1500 in 10 years • yield = (1500/1000)1/10 -1 = .0414 = 4.14% • As the price paid for a bond increases, the yield (interest rate) falls.

14. The Bond Market. • Determinants of bond yields • Risk • Debt rating agencies: • Moody’s & Standard and Poors • AAA=superior quality • C=imminent default • Inflation risk. • Term • Longer term bonds have greater inflation and default risk.

15. The Bond Market. • Yield curve • Shows relationship between yield and term on government bonds • Slope of yield curve reflects • Expectations of future short term interest rates • Greater risk of long term bonds • If short term interest rates are expected to be constant in the future, yield curve will slope upward reflecting risk premia for longer term bonds. • A steepening of the yield curve suggests that financial markets believe short term interest rates will be rising in the future. • The dynamic yield curve • The bond market

16. Interest Rate Determination • Money Market Equilibrium • The Fed determines the quantity of money supplied and on any given day, that quantity is fixed. • The supply of money curve is vertical at the given quantity of money supplied. • Money market equilibrium determines the interest rate.

17. Interest Rate Determination

18. Interest Rate Determination • If the Fed increases the money supply, interest rates will fall. • As money supply increases, banks have more loanable funds, interest rates are reduced. • Fed has better control over short term than long term rates.

19. Short-Run Effects of Money onReal GDP, and the Price Level • Ripple Effects of Monetary Policy • If the Fed increases the interest rate, three events follow: • Investment and consumption expenditures decrease. • The value of the $ rises and net exports decrease. • A multiplier process unfolds.

20. Short-Run Effects of Money onReal GDP, and the Price Level • The Fed tightens the money supply to reduce inflationary pressure. Real GDP decreases and the price level falls.

21. Short-Run Effects of Money onReal GDP, and the Price Level • Effects of an Increase in the money supply to recover from recession.

22. Short-Run Effects of Money onReal GDP, and the Price Level • Limitations of Monetary Stabilization Policy • The impact depends on the sensitivity of expenditure plans to the interest rate. • The effects of monetary policy can take a long time be realized. • These effects are variable and hard to predict.

23. LR Effects of Money on Real GDP and the Price Level • An increase in the money supply will increase AD. • SR Effects: • Real wage falls • Unemployment falls • Real GDP increases. • Price level rises.

24. LR Effects of Money on Real GDP and the Price Level • Movement to new LR equilibrium • the money wage rate rises • SAS decreases. • RGDP decreases • P rises • Compared to original LR equil. • No change in RGDP, unempl, real wage • Higher prices, nominal GDP & nominal wage

25. Quantity Theory of Money • Equation of exchange • MV = Py • M=money supply • V=velocity of money • P=price level • y=real GDP

26. Quantity Theory of Money • MV = PY • Q-theory assumes that velocity and potential GDP are not affected by the quantity of money. • P = (MV/Y) • Because (V/Y) does not change when M changes, a change in M brings a proportionate change in P.

27. Quantity Theory of Money

28. Quantity Theory of Money • P = (V/Y)M • Divide this equation by • P = (V/Y)M • and the term (V/Y) cancels to give • P/P = M/M • P/P is the inflation rate • M/M is the growth rate of the quantity of money.

29. Quantity Theory of Money • Historical Evidence on the Quantity Theory of Money • U.S. money growth and inflation are correlated • more so in the long run than the short run • broadly consistent with the quantity theory.

30. Quantity Theory of Money

31. Quantity Theory of Money Decade averages show stronger relationship

32. Quantity Theory of Money • International Evidence