Chapter Eleven

1. Chapter Eleven Modeling Money

2. Why Do We Need a Model? • To show how the functions of money affect the demand for money • To learn how money interacts with other variable in the economy, such as income, prices, and interest rates

3. The ATM Model of Demand for Cash • How do we decide how often to go to the ATM? • The costs (both in time and money) of using the ATM increase as we go more often • The amount we want to spend • The risk of loss or theft • Opportunity of holding cash in lieu of earning money in the bank (dependent upon nominal interest rates)

4. The ATM Model (cont’d) • ATM visits often follow a saw-tooth pattern • Cash balances decline as Tracy nears a visit to the ATM

5. The ATM Model (cont’d) • Tracy needs to minimize her total cost of holding cash • Her average cash balance over time is considered to represent her demand for money

6. The ATM Model (cont’d) • Tracy’s ATM visits can be affected by a number of factors

7. Weaknesses of the ATM Model • The variables above only apply to a single person • Building a more complete model necessitates the consideration of exogenous and endogenous variables

8. Exogenous & Endogenous Variables • Exogenous variables occur outside a model • In the ATM model, four variable are exogenous • Nominal interest rate • Tracy’s daily spending • Costs of a visit to the ATM • Possibility of loss or theft • Endogenous variables are determined within the model itself • In the ATM model, three variable are exogenous • Number of days between visits to the ATM • Amount withdrawn at each visit • Average cash balances

9. Model Conclusions • General-equilibrium models are ones in which all variables are endogenous • Partial-equilibrium models are ones in which at least some variables are exogenous • The ATM model is a partial-equilibrium model • Economists generally prefer to work with general-equilibrium models because they are more broadly applicable and believable • Partial-equilibrium models, however, are often useful building blocks for general-equilibrium models

10. The Liquidity Preference Model • The liquidity-preference model illustrates how money demand and supply determine the nominal interest rate • The model assumes that people choose between either holding cash (a preference for liquidity) or investing it at the nominal interest rate • The model assumes a fixed money supply, as controlled by the Fed • In general, people will prefer to invest more money when the nominal interest rate (the price of money) is higher

11. The Liquidity Preference Model (cont’d) • The slope of the demand curve depends on how sensitive demand is to the level of i. The location of the demand curve depends on other variables, such as incomes

12. The Liquidity Preference Model (cont’d) • The equilibrium point represents the nominal interest rate I • What happens when the nominal interest rate is above equilibrium? • The quantity of money demanded would be less than the quantity of money supplied • Because rates are higher, people would use their income to invest (buy bonds) instead of holding cash, thereby raising the price of bonds • A rise in the price of bonds implies a fall in the nominal interest rate • This process would continue until equilibrium was restored

13. The Liquidity Preference Model (cont’d) • The liquidity-preference model is still not a general-equilibrium model because the prices of goods and services, the money supply, and people’s incomes remain exogenous • The endogenous variables are the quantity of money demanded, the nominal interest rate, the equilibrium quantity of money, and people’s spending • The model can be used to illustrate how changes in the exogenous variables affect the endogenous variables

14. The Liquidity Preference Model (cont’d) • When the money supply (exogenous) increases, the nominal interest rate (endogenous) declines

15. The Liquidity Effect • This model demonstrates the liquidity effect, the inverse relationship between the money supply and the nominal interest rate • This is widely believed to be the primary short-run effect of expansionary monetary policy • This also correlates to business cycles- when people’s incomes rise and/or as the prices of goods and services increase, they increase their demand for money, and vice versa

16. Income and the Liquidity Effect • As people’s incomes rise and the money supply is held constant, upward pressure is brought to bear on nominal interest rates

17. The Price Level and the Liquidity Effect The demand for money is proportional to the price level Prices can also be considered in terms of real money demand, which shows that demand for money is dependent on income and the nominal interest rate As the real money demand function is not affected by changes in the money supply or the price level, it is helpful for analyzing the demand for money over time

18. The Dynamic Model of Money • The liquidity-preference model is a static model, or one which does not allow for changes in variables over time • A dynamic modeldoes allow for such changes • Time is important to include in a model of money because, like financial investments, money can also serve as a store of value • Further, both the inflation rate and the nominal interest rate are both dependent on time

19. The Dynamic Model of Money (cont’d) • The dynamic model of money starts with the economy in a steady state, or long-run equilibrium • This enables us to describe what the endogenous variables will do if not disturbed. • Shocks can affect variables in both the short- and long-run • The dynamic model is interested in how these shocks affect the model

20. Effects of an Increase in the Money Supply • The economy is in a static state until time 1, when the Fed increases the money supply, causing nominal interest rates to decline, and incomes and the price level to rise

21. Price Level & Income Effects • The increase in the money supply causes a decline in interest rates, causing a subsequent increase in the demand for money • This situation is described by the price-level effect, as an increase in the price level increases the demand for money • Increases in income also raise the demand for money, pushing up nominal interest rates, also known as the income effect • Both effects move interest rates in the opposite direction as the liquidity effect, which dominated at first (between time 1 and time 2)

22. Effects of an Increase in the Growth Rate of the Money Supply • The economy is in a static state until time 1, when the Fed increases the money supply, causing nominal interest rates to decline, and incomes and the price level to rise

23. Effects of a Well-Anticipated Increase in the Growth Rate of the Money Supply • When people expect inflation to rise quickly, the nominal interest rate is also likely to rise quickly, possibly eradicating the liquidity effect

24. Using Money Models in Practice • The Fed must know how much money people want to hold so that it can supply the appropriate amount • A problem with money models is that in fact there is more than one kind of money; economists do not necessarily know which one a model specifies • They may use a measure of money most closely related to the theoretical model • They may make the model more complicated so that it matches actual data more closely • It is easier to account for changes over time by using logarithms of demand for money and income