Slides by Alex Stojanovic

1. ECONOMICS ELEVENTHEDITION LIPSEY & CHRYSTAL Chapter 21 THE ROLE OF MONEY IN MACROECONOMICS Slides by Alex Stojanovic

2. Learning Outcomes • There is an important distinction between money values and real (or relative) values • The market price of bonds is inversely related to the interest rate • Monetary equilibrium occurs where people are willing to hold the existing stock of money and bonds at the current interest rate • A rise in interest rates reduces aggregate demand, and vice versa • Monetary and fiscal policies may assist the stabilization of the economy and control inflation, but inappropriate policies can make things worse • Central banks have the power to set interest rates because they are the monopoly supplier of high-powered money (notes and coins + deposits at the central bank) • UK monetary policy is focused on an inflation target • The goal of European Central Bank monetary policy is price stability across the eurozone

3. The Equilibrium Interest Rate MS MD Nominal Rate of Interest E0 i0 M0 Quantity of Money

4. The Equilibrium Interest Rate MS MD Nominal Rate of Interest E0 i0 i1 M0 M1 Quantity of Money

5. The Equilibrium Interest Rate MS MD i2 Nominal Rate of Interest E0 i0 i1 M2 M0 M1 Quantity of Money

6. The Equilibrium Interest Rate • The equilibrium interest rate arises where demand for money equals supply of money. • A given amount of money, M0, is shown by the vertical supply curve Ms. The demand for money is Md; its negative slope indicates that a fall in the rate of interest causes the quantity of money demanded to increase. Equilibrium is at E0, with a rate of interest i0..

7. The Equilibrium Interest Rate • If the interest rate is i1, there will be an excess demand for money of M1-M0. Bonds will be offered for sale in an attempt to increase money holdings. • This will force the rate of interest up to i0 (the price of bonds falls), at which point the quantity of money demanded is equal to the fixed supply, M0. • If the interest rate is i2, there will be an excess money balances. This will force the rate of interest down to i0 (the price of bonds rises), at which point the quantity of money demanded has risen to equal the fixed money supply, M0.

8. Interest Rates and Money Supply Changes MS MD Nominal Rate of Interest E0 i0 E1 i1 M0 M1 Quantity of Money

9. Interest Rates and Money Supply Changes • A change in the policy-determined interest rate requires the money supply to change. • In the figure the initial money supply is shown by the vertical line Ms0, and the demand for money is shown by the negatively sloped curve Md. The initial equilibrium is at E0, with corresponding interest rate of interest i0.. • The monetary authorities choose to lower the interest rate from i0 to i1. In order to achieve this they must generate an increase in the money supply, from Ms0 to Ms1. The new equilibrium is at E1. • Starting at E1, with Ms1 and i1, it can be seen that a decrease in the money supply to Ms0 would be required to achieve an increase in the interest rate from i1 to i0.

10. B E1 I The Effect of Changes in the Interest Rate Investment Spending MD MS1 ID MS0 E0 i0 A i0 Rate of Interest Rate of Interest i1 i1 0 0 M0 M1 I0 I1 Quantity of Money Investment expenditure (i). Money Demand and Supply (ii). The investment demand function

11. The Effect of Changes in the Interest Rate Investment Spending • A reduction in the rate of interest increases desired investment expenditure. • Initial equilibrium is at E0, with a quantity of money of M0 (shown by the vertical money supply curve Ms0), an interest rate of i0 (point A in part (ii)). • The monetary authorities then lower the interest rate to i1 (and increase the money supply to M1), and this increases investment expenditure by Δl to l1 (point B). • A policy-induced rise in the interest rate from i0 to i1 is accompanied by a fall in the money stock from M1 to M0 and leads investment to fall by Δl from l1 to l0.

12. I The Effects of Changes in the Interest Rate on Aggregate Demand AE = Y AE0 Desired Expenditure E0 45o (i). Shift in Aggregate Expenditure 0 Y0 Real GDP AD1 E0 Price Level P0 (ii). Shift in Aggregate Demand Y0 Real GDP

13. The Effects of Changes in the Interest Rate on Aggregate Demand AE = Y E1 AE1 AE0 Desired Expenditure E0 I 45o (i). Shift in Aggregate Expenditure 0 Y0 Y1 Real GDP AD1 AD0 E0 E1 Price Level P0 (ii). Shift in Aggregate Demand Y1 Y0 Real GDP

14. The Effects of Changes in the Interest Rate on Aggregate Demand • Changes in the interest rate cause shifts in the aggregate expenditure and aggregate demand functions. • A fall in the interest rate increased desired investment expenditure by Δl. Here, in part (i) the aggregate expenditure function shifts up by Δl, from AE0 to AE1. • At the fixed price level P0, equilibrium GDP rises from Y0 to Y1, shifting the aggregate demand curve horizontally from AD0 to AD1 in part (ii). • When the interest rate rises (as from i1 to i0 in figure 26.4), investment falls by Δl, thereby shifting aggregate expenditure from AE1 to AE0. • At the fixed price level P0 this reduces equilibrium income from Y1 to Y0 and shifts the AD curve from AD1 to AD0.

15. Aggregate demand shocks

16. Aggregate demand shocks A positive demand shock leads to a temporary boom in GDP and a permanent rise in the price level, while a negative demand shock leads to a temporary fall in output and (ultimately) lower prices. Consider an initial position at point A with the economy at Y* with an initial price level P0. A positive demand shock shifts the AD curve from AD0 to AD1. This shift will be greater with a pegged interest rate than with a fixed money stock, as the money supply will increase, reinforcing the rightward shift. The economy will move from point A to a point such as B.

17. Aggregate demand shocks The inflationary gap will now lead to upward pressure on money wages. As wages rise, the rise is partly passed on in higher prices, and the SRAS curve shifts leftward from SRAS0 to SRAS1. At the equilibrium, point C, the economy has returned to the initial level of potential GDP, Y*, but at a higher price level. A negative demand shock shifts the AD curve from AD0 to AD2, and the economy moves from point A to a point such as D. The recessionary gap eventually leads to wage cuts, and, as these are passed on into prices, output recovers and the economy moves to a point such as E with price level P2.

18. Supply shocks

19. Supply shocks A positive supply shock increases output and lowers prices temporarily, while a negative supply shock lowers output and raises prices temporarily. The economy starts at point A. A positive supply shock shifts the SRAS curve from SRAS0 to SRAS2. This stimulates output and lowers the price level as the economy moves from A to E. However, if the monetary authorities peg the interest rate, they will resist the interest rate fall necessary to increase investment and instead will reduce the money supply, taking the economy from A to D. With a fixed money stock, the move from A to E will eventually be reversed as the inflationary gap leads to money wage rises and SRAS2 shifts back to its original position.

20. Supply shocks A negative supply shock shifts the SRAS curve from SRAS0 to SRAS1. This raises prices and lowers output as the economy moves from A to B. With a fixed money stock the recessionary gap will eventually lead to lower wages and prices, SRAS will shift back to SRAS0, and the economy will return to point A. However, with pegged interest rates the money stock will increase (as the authorities accommodate the supply shock) and the economy will move from A to C.

21. Bank of England CPI inflation forecast

22. GDP gap, Japan, 1980-2007

23. Inflation and the interest rate, Japan, 1980-2007

24. The IS Curve AE0 (I0) AE1 (I1) Desired Expenditure 45o [i] Real GDP 0 i1 Interest rate i0 [ii] 0 Y1 Y0 Real GDP

25. The IS Curve • The IS curve shows the equilibrium level of GDP associated with each given rate of interest. • It shows combinations of the interest rate and GDP for which desired expenditure equals actual national output, and for which injections equal withdrawals. • Part (i) shows a fall in AE resulting from a fall in investment from l0 to l1. This fall in l is caused by a rise in the interest rate from i0 to i1. The fall in investment produces a fall in GDP from Y0 to Y1. • Part (ii) shows the resulting combinations of the interest rate and real GDP. For given values of exogenous expenditures, i0 leads to a level of GDP Y0, and i1 leads to level of GDP Y1. • Choosing any other level of the interest rate and following through its effect on GDP via investment produces another point on the IS curve.

26. The LM Curve MS LM0 Rate of Interest Rate of Interest Quantity of Money Real GDP 0 [i] [ii]

27. The LM Curve MS LM0 Rate of Interest Rate of Interest i0 i0 MD0(Y0) Quantity of Money 0 Y0 Real GDP [i] [ii]

28. The LM Curve LM2 MS LM0 LM1 i1 i1 Rate of Interest Rate of Interest i0 i0 MD1(Y1) MD0(Y0) Quantity of Money Y0 Y1 Real GDP 0 [i] [ii]

29. The LM Curve • The LM curve shows the combinations of real GDP and interest rate that are consistent with the equality of money demand and supply for a given nominal money supply and given price level. • Part (i) shows equilibrium in the money market with a given money supply and an MD function that is negatively sloped. • At an initial level of GDP Y0 the demand curve for money is given by MD0 and the equilibrium interest rate is i0.

30. The LM Curve • At higher levels of GDP the MD curve shifts to the right (higher levels of GDP cause higher transactions demand for money). When GDP increases to Y1, the money demand curve shifts to MD1 and the associated equilibrium interest rate rises to i1. • In part (ii) the LM curve LM0 plots out the equilibrium interest rate associated with each possible Y and the given money stock MS. This is a positively sloped curve. • An increase in the nominal money supply shifts the LM curve parallel to the right, such as to LM1, and a decrease in the nominal money supply shifts the LM curve to the left, such as to LM2.

31. IS/ LM and Aggregate Demand [i] Rate of Interest IS Quantity of Money Rate of Interest [ii] AD 0 Real GDP

32. IS/ LM and Aggregate Demand LM0(P0) [i] i0 Rate of Interest IS Y0 Quantity of Money Rate of Interest [ii] P0 AD Y0 0 Real GDP

33. IS/ LM and Aggregate Demand LM1(P1) i1 LM0(P0) [i] i0 Rate of Interest IS Y1 Y0 Quantity of Money Rate of Interest P1 [ii] P0 AD 0 Real GDP Y1 Y0

34. IS/ LM and Aggregate Demand • The AD curve plots the IS/LM equilibrium level of GDP for each given price level (holding all exogenous expenditures and the nominal money supply constant). • Part (i) has the initial position as the intersection of LM0 (which is drawn with price level P0) with the IS curve. • This gives the overall equilibrium levels of real GDP and the interest rate as Y0 and i0. • At higher price levels the LM curve shifts to the left (because the real money supply falls). • At price level P1 the LM curve is given by LM1, and this leads to equilibrium GDP and interest rate of Y1 and i1. • Part (ii) plots out the resulting combinations of the price level and GDP. This is the aggregate demand curve, AD.

35. THE ROLE OF MONEY IN MACROECONOMICS Money values and relative values • Money prices do not matter if they all change at once along with all money incomes and assets. What matters for the real economy is relative prices. • Money illusion arises when people are deceived by changes in all relevant money prices into thinking that something real has changed when it has not.

36. THE ROLE OF MONEY IN MACROECONOMICS The valuation of financial assets • For simplicity we group all forms in which wealth is held into money, which is a medium of exchange, and bonds, which earn a higher interest return than money and can be turned into money by being sold at a price that is determined on the open market. • The price of existing bonds varies negatively with the rate of interest. • A rise in the interest rate lowers the prices of all outstanding bonds. • The longer a bond’s term to maturity, the greater the change in its price will be for a given change in the interest rate.

37. THE ROLE OF MONEY IN MACROECONOMICS The Supply of Money and the Demand for Money • The value of money balances that the public wishes to hold is called the demand for money. • It is a stock [not a flow], measured in the United Kingdom as so many millions of pounds. • Money balances are held, despite the opportunity cost of bond interest forgone, because of the transactions, precautionary, and speculative motives. • They have the effect of making the demand for money vary positively with real GDP, the price level, and wealth, and negatively with the nominal rate of interest. • The nominal demand for money varies proportionally with the price level.

38. THE ROLE OF MONEY IN MACROECONOMICS • When there is an excess demand for money balances, people try to sell bonds. • This pushes the price of bonds down and the interest rate up. When there is an excess supply of money balances, people try to buy bonds. • This pushes the price of bonds up and the rate of interest down. • Monetary equilibrium is established when people are willing to hold the existing stocks of money and bonds at the current rate of interest.

39. THE ROLE OF MONEY IN MACROECONOMICS Monetary Forces and Aggregate Demand • With given inflationary expectations, changes in the nominal interest rate translate into changes in the real interest rate. • A change in the real interest rate causes desired investment to change along the investment demand function. • This shifts the aggregate desired expenditure function and causes equilibrium GDP to change. • A rise in interest rates [or a decrease in the supply of money] reduces aggregate demand; that is, it shifts AD to the left. • A cut in interest rates [or an increase in the money supply] increases aggregate demand; that is, it shifts AD to the right.

40. THE ROLE OF MONEY IN MACROECONOMICS • The negatively sloped aggregate demand curve indicates that the higher the price level, the lower the equilibrium GDP. • The explanation lies in part with the effect of money on the adjustment mechanism: other things being equal [for a given money stock], the higher the price level, the higher the demand for money and the rate of interest, the lower the level of investment and therefore the lower the aggregate expenditure function, and thus the lower the equilibrium level of GDP.

41. THE ROLE OF MONEY IN MACROECONOMICS Macroeconomic cycles and aggregate shocks • A positive demand shock (starting at potential GDP) will trigger a temporary boom in output and lead to a permanent increase in the price level. The latter will be greater if interest rates are pegged than if the money stock is fixed. • A negative demand shock will cause a recession, and the automatic adjustment mechanisms may be slow to return the economy to equilibrium. • A positive supply shock will increase output and reduce the price level temporarily, but inflationary pressure will eventually return the economy close to its initial position (where there is no permanent impact on potential GDP). • A negative supply shock is associated with rising prices and falling output—a situation known as stagflation.

42. THE ROLE OF MONEY IN MACROECONOMICS • Monetary and fiscal policies can assist the return of the economy to equilibrium, but inappropriate policies can also make things worse. • Monetary authorities’ reactions are well described by the Taylor rule: interest rates are raised when inflation exceeds target and when GDP exceeds potential, and vice versa. Implementation of monetary policy • Central banks are the ultimate suppliers of cash to the monetary system, and they have the power to set short-term interest rates in the money markets. • The Bank of England uses the two-week repo rate as its policy instrument. • The UK inflation target is set by the government, and the Monetary Policy Committee has been delegated the responsibility to keep inflation close to target.

43. THE ROLE OF MONEY IN MACROECONOMICS An Alternative Derivation of the AD Curve: IS/LM • Combinations of the interest rate and equilibrium GDP for which desired expenditure equals actual real national output can be represented by the IS curve, which is negatively sloped. • Combinations of real GDP and the equilibrium interest rate for which money demand equals money supply can be represented by the LM curve, which is positively sloped. • The AD curve can be derived from the IS/LM model, holding all exogenous expenditures and the nominal money supply constant.

44. THE ROLE OF MONEY IN MACROECONOMICS • A rise in the price level lowers the real money supply, leading to higher interest rates and lower GDP. • A fall in the price level leads to an increase in the real money supply, which lowers interest rates and increases GDP. • Hence the AD curve is negatively sloped. • This reinforces our earlier discussion of why AD has a negative slope.