Download Money Markets PPT - Leon County Schools

Chapter 27: Money, Interest, and Inflation
1) The Money Market
2) The Velocity of Money
3) The Equation of Exchange
Consume or Save
THE DEMAND FOR MONEY
© 2011 Pearson Education
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Demand, Da
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Total demand
for money, Dm
Rate of interest, i (percent)
+
Rate of interest, i (percent)
Rate of interest, i (percent)
Transactions
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0 50 100 150 200 250 300
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Amount of money
demanded (billions
of dollars)
Amount of money
demanded (billions
of dollars)
Amount of money
demanded (billions
of dollars)
27.1 MONEY AND THE INTEREST RATE
 The Demand for Money
Quantity of money demanded is the amount of money
that households and firms choose to hold.
We hold cash in times of uncertainty. We hold cash to pay
bills and consume in an immediate sense.
Opportunity cost of holding cash - when the interest
rate is high the opportunity cost of holding money is high
which means quantity demanded is low; when the
interest is low, the opportunity cost of holding money is
low (QD is high). The interest rate that we are referring to is
called the nominal interest rate.
Nominal Interest Rate= Real Interest Rate + Inflation rate
27.1 MONEY AND THE INTEREST RATE
The lower the
nominal interest
rate—the opportunity
cost of holding
money—the greater
is the quantity of
money demanded.
Ex: A higher interest
rate at the bank tells
me to hold less cash,
a lower one makes
me hold more cash.
27.1 MONEY AND THE INTEREST RATE
Other things remaining
the same,
1. An increase in the
nominal interest rate
decreases the
quantity of real
money demanded.
2. A decrease in the
nominal interest rate
increases the
quantity of money
demanded.
27.1 MONEY AND THE INTEREST RATE
 Changes in the Demand for Money
A change in the nominal interest rate brings a change in
the quantity of money demanded.
A change in any other influence on money holdings
changes the demand for money. The three main
influences that shift Dm:
• Changes to the price level
• Changes in Real GDP
• Changes in Financial Technology
Money Markets
27.1 MONEY AND THE INTEREST RATE
Financial Technology
Daily interest on checking deposits, automatic transfers
between checking and savings accounts, automatic teller
machines, debit cards, and smart cards have increased
the marginal benefit of money and increased the demand
for money.
Credit cards have made it easier to buy goods and
services on credit and have decreased the demand for
money because it’s easier to pay with a credit card then
to get money.
27.1 MONEY AND THE INTEREST RATE
1. If the interest rate is 6
percent a year, the quantity
of money held exceeds the
quantity demanded.
People buy bonds, the
price of a bond rises, and
the interest rate falls.
As the nominal interest
rate falls, the quantity of
money demanded
increases.
27.1 MONEY AND THE INTEREST RATE
2. If the interest rate is 4
percent a year, the quantity
of money held is less than
the quantity demanded.
People sell bonds, the
price of a bond falls, and
the interest rate rises.
A rise in the nominal
interest rate decreases the
quantity of money
demanded.
27.1 MONEY AND THE INTEREST RATE
 The Supply of Money
The supply of money is shown by a vertical line on
the graph. It’s vertical because it’s unrelated to interest
rates.
The quantity of money supplied is determined by the
actions of the banking system and the Fed.
On any given day, the quantity of money is fixed
independent of the interest rate.
27.1 MONEY AND THE INTEREST RATE
 The Nominal Interest Rate
The FED adjusts the supply of money to change the
interest rate. They do this by using expansionary or
contractionary monetary policy.
When they set policy the interest rate will move and the
Dm will move to meet the Sm.
There are three shifters of the Sm: reserve
requirement, discount rate, and OMO.
Shifters of the Money Supply
27.1 MONEY AND THE INTEREST RATE
Changing the Interest Rate
To change the interest rate, the Fed changes the
quantity of money.
If the Fed increases the quantity of money, the interest
rate falls.
If the Fed decreases the quantity of money, the interest
rate rises.
Figure 27.3 on the next slide illustrates these changes.
27.1 MONEY AND THE INTEREST RATE
1. If the Fed increases the
quantity of money and
the supply of money
curve shifts to MS1, the
interest rate falls to 4
percent a year.
2. If the Fed decreases the
quantity of money and
the supply of money
curve shifts to MS2, the
interest rate rises to 6
percent a year.
27.1 MONEY AND THE INTEREST RATE
The interest Rate and Bond Price Move in Opposite
Directions
When the government issues a bond, it specifies the dollar
amount of interest that it will pay each year.
The interest rate on the bond is the dollar amount received
divided by the price of the bond.
If the price of the bond falls, the interest rate rises.
If the price of the bond rises, the interest rate falls.
27.1 MONEY AND THE INTEREST RATE
Interest Rate Adjustment
• When the interest rate is above its equilibrium
level, the quantity of money supplied exceeds the
quantity of money demanded.
• People are holding too much money, so they try to
get rid of money by buying other financial assets.
• The demand for financial assets increases, the
prices of these assets rise, and the interest rate
falls.
27.1 MONEY AND THE INTEREST RATE
Conversely,
• When the interest rate is below its equilibrium
level, the quantity of money demanded exceeds
the quantity of money supplied.
• People are holding too little money, so they try to
get more money by selling other financial assets.
• The demand for financial assets decreases, the
prices of these assets fall, and the interest rate
rises.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
 The Money Market in the Long Run
The long run refers to the economy at full employment
or when we smooth out the effects of the business
cycle.
In the short run, the interest rate adjusts to make the
quantity of money demanded equal the quantity of
money supplied.
In the long run, the price level does the adjusting.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Long-Run Demand for Money
In the long run, equilibrium in the market for loanable
funds determines the real interest rate.
The nominal interest rate that influences money holding
plans equals the real interest rate plus the inflation rate.
If the inflation rate is zero, the nominal interest rate in
the long run equals the real interest rate.
The interest rate is determined by real forces.
The variable that adjusts in the long run is the “price” of
money.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The lower the “price” of money, the greater is the
quantity of money that people are willing to hold.
The “price “ of money is the value of money.
The Value of Money
The value of money is the quantity of goods and
services that a unit of money will buy.
It is the inverse of the price level, P, which equals the
GDP price index divided by 100. That is,
Value of money = 1/P.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
Money Market Equilibrium in the Long Run
All the influences on money holding except the price
level are determined by real forces in the long run and
are given.
In the long run, money market equilibrium determines
the value of money.
Figure 27.4 on the next slides illustrates the long-run
money market equilibrium.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The long-run demand for
money is determined by
potential GDP and the
equilibrium interest rate.
The LRMD curve shows
how the quantity of
money that households
and firms plan to hold, in
the long run, depends on
the value of money.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The MS curve shows the
quantity of money
supplied, which is $1
trillion.
The price level adjusts to
make the value of money
equal 1 and achieve
long-run money market
equilibrium.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
 A Change in the Quantity of Money
Starting from a long-run equilibrium, suppose that the
Fed increases the quantity of money by 10 percent.
In the short run, the greater quantity of money lowers
the nominal interest rate.
With the lower interest rate, people and firms spend
more.
But with real GDP equal to potential GDP, prices start to
rise.
At the new equilibrium, the price level will have risen by
10 percent, from 1.0 to 1.1.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
Figure 27.5 illustrates the
outcome.
1. The quantity of money
increases by 10
percent from $1 trillion
to $1.1 trillion and the
supply of money curve
shifts from MS0 to MS1.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
2. The price level rises by
10 percent and the
value of money falls by
10 percent to restore
long-run money market
equilibrium.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
A key proposition about the quantity of money and the
price level is that:
In the long run and other things remaining the same, a
given percentage change in the quantity of money
brings an equal percentage change in the price level.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Price Level in a Baby-Sitting Club
A baby sitting club uses tokens to pay for neighbor’s
baby sitting services. One sit costs one token.
The organizers double the number of tokens by giving a
token to each member for each token currently held.
Equilibrium in this local baby-sitting market is restored
when the price of sit doubles to two tokens.
Nothing real has changed, but the nominal quantity of
tokens and the price level have doubled.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Quantity Theory of Money
Quantity theory of money is the proposition that
when real GDP equals potential GDP, an increase in
the quantity of money brings an equal percentage
increase in the price level (other things remaining the
same).
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Velocity of Circulation and Equation of
Exchange
Velocity of circulation is the number of times in a
year that the average dollar of money gets used to buy
final goods and services.
Equation of exchange is an equation that states that
the quantity of money multiplied by the velocity of
circulation equals the price level multiplied by real GDP.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
Define:
• The velocity of circulation = V
• The quantity of money = M
• The price level = P
• Real GDP = Y
Then the equation of exchange is
MV=PY
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The Quantity Theory Prediction
The equation of exchange, M  V = P  Y, implies that
P = M  V  Y.
On the left is the price level and on the right are all the
things that influence the price level.
These influences are the quantity of money, the velocity
of circulation, and real GDP.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
To turn the equation into a theory of what determines the
price level, we use two facts:
1. In the long run, real GDP equals potential GDP, which is
independent of the quantity of money.
2. The velocity of circulation is relatively stable and does
not change when the quantity of money changes.
So, in the long run, V and Y are constant and the
price level P is proportional to the quantity of money M.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
Inflation and the Quantity Theory of Money
The equation of exchange tells us the relationship
between the price level, the quantity of money, the velocity
of circulation, and real GDP.
This equation implies a relationship between the rates of
change of these variables, which is
Money growth + Velocity growth =
Inflation rate + Real GDP growth
Figure 27.6 on the next slide illustrates the relationship.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The velocity of circulation grows at 1 percent a year and
real GDP grows at 3 percent a year.
If the quantity of
money grows at
2 percent a year,
the inflation rate
is zero.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The velocity of circulation grows at 1 percent a year and
real GDP grows at 3 percent a year.
If the quantity of
money grows at
4 percent a year,
the inflation rate is
2 percent a year.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
The velocity of circulation grows at 1 percent a year and
real GDP grows at 3 percent a year.
If the quantity of
money grows at
10 percent a year,
the inflation rate is
8 percent a year.
EYE on the CAUSE OF INFLATION
Does Inflation, Deflation, or a Stable Price Level
Lie in Our Future?
According to the quantity theory of money, whether we face
a future with inflation, deflation, or a stable price level
depends entirely on the rate at which the Fed permits the
quantity of money to grow.
But is the quantity theory correct?
Does it explain our past inflation with enough accuracy to be
a guide to future inflation?
EYE on the CAUSE OF INFLATION
Does Inflation, Deflation, or a Stable Price Level
Lie in Our Future?
The quantity theory does not predict the year-to-year
changes in the inflation rate.
The quantity theory does an especially bad job of explaining
2008 and 2009 because in those years, the velocity of
circulation tumbled.
But on average, over a number of years, the quantity theory
is a remarkably accurate predictor of the inflation rate.
The figure (on the next slide) shows that the quantity theory
explains our past decade average inflation rates.
EYE on the CAUSE OF INFLATION
Does Inflation, Deflation, or a Stable Price Level
Lie in Our Future?
During the 1960s: M2 velocity was constant,
the quantity of
M2 grew at 6.7
percent a year,
real GDP grew
at 4.4 percent a
year,
and the inflation
rate was 2.3
percent a year.
EYE on the CAUSE OF INFLATION
Does Inflation, Deflation, or a Stable Price Level
Lie in Our Future?
During the 1970s: M2 velocity was constant,
the M2 growth
rate increased,
real GDP
growth was
slowed,
and the inflation
rate rose.
EYE on the CAUSE OF INFLATION
Does Inflation, Deflation, or a Stable Price Level
Lie in Our Future?
During the 1980s: M2 velocity was constant,
the M2 growth
rate slowed,
real GDP
growth was
steady,
and the inflation
rate fell.
EYE on the CAUSE OF INFLATION
Does Inflation, Deflation, or a Stable Price Level
Lie in Our Future?
During the 1990s: M2 velocity increased,
M2 growth
slowed,
real GDP
remained
steady,
and the inflation
rate fell.
EYE on the CAUSE OF INFLATION
Does Inflation, Deflation, or a Stable Price Level
Lie in Our Future?
During the 2000s: M2 velocity decreased,
M2 growth
increased,
real GDP fell,
and the inflation
rate remained
steady.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
Changes in the Inflation Rate
Because, in the long run, both velocity growth and real
GDP growth are independent of the growth rate of
money:
A change in the money growth rate brings an equal
change in the inflation rate.
27.2 MONEY, THE PRICE LEVEL, AND INFLATION
Hyperinflation
If the quantity of money grows rapidly, the inflation rate
will be very high.
An inflation rate that exceeds 50 percent a month is
called hyperinflation.
Highest inflation rate in recent times was in Zimbabwe,
where inflation peaked at 231,150,888.87 percent a
year in July 2008.
27.3 THE COST OF INFLATION
Inflation is costly for four reasons:
• Tax costs
• Shoe-leather costs
• Confusion costs
• Uncertainty costs
27.3 THE COST OF INFLATION
Tax Costs
Government gets revenue from inflation.
Inflation Is a Tax
You have $100 and you could buy 10CDs ($10 each)
today or hold the $100 as money.
If the inflation rate is 5 percent a year, at the end of the
year the 10 CDs will cost you $105.
If you held $100 as money for the year, you have paid a
tax of $5 on your holding $100 of money.
27.3 THE COST OF INFLATION
Inflation, Saving, and Investment
The income tax on nominal interest income drives a wedge
between the before-tax interest rate paid by borrowers and
the after-tax interest rate received by lenders.
The fall in the after-tax interest rate weakens the incentive
to save and lend.
The rise in the before-tax interest rate weakens the
incentive to borrow and invest.
Inflation increases the nominal interest rate, and because
income taxes are paid on nominal interest income, the true
income tax rate rises with inflation.
27.3 THE COST OF INFLATION
The higher the inflation rate, the higher is the true
income tax rate on income from capital.
And the higher the tax rate, the higher is the interest
rate paid by borrowers and the lower is the after-tax
interest rate received by lenders.
With a fall in saving and investment, capital
accumulation and real GDP growth slows.
27.3 THE COST OF INFLATION
Shoe-Leather Costs
So-called “shoe-leather” costs arise from an increase in
the velocity of circulation of money and an increase in
the amount of running around that people do to try to
avoid incurring losses from the falling value of money.
27.3 THE COST OF INFLATION
When money loses value at a rapid anticipated rate, it
does not function well as a store of value and people try
to avoid holding it.
They spend their incomes as soon as they receive
them, and firms pay out incomes—wages and
dividends—as soon as they receive revenue from their
sales.
The velocity of circulation increases.
27.3 THE COST OF INFLATION
Confusion Costs
Money is our measuring rod of value.
Borrowers and lenders, workers and employers, all
make agreements in terms of money.
Inflation makes the value of money change, so it
changes the units on our measuring rod.
27.3 THE COST OF INFLATION
Uncertainty Costs
A high inflation rate brings increased uncertainty about
the long-term inflation rate.
Increased uncertainty also misallocates resources.
Instead of concentrating on the activities at which they
have a comparative advantage, people find it more
profitable to search for ways of avoiding the losses that
inflation inflicts.
Gains and losses occur because of unpredictable
changes in the value of money.
27.3 THE COST OF INFLATION
How Big Is the Cost of Inflation?
The cost of inflation depends on its rate and its
predictability.
The higher the inflation rate, the greater is its cost.
And the more unpredictable the inflation rate, the
greater is its cost.