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CHAPTER 3 The Role of Money and Credit Learning Objectives What the interest rate is How the supply of and demand for money—and/or credit flows—influence the interest rate How, in general, changes in money and credit influence nominal GDP, real GDP, and pr ices What the inflation rate is and how to calculate it Chapter Outline I. II. III. IV. V. Money and Credit Matter The Demand for and Supply of Money A. The Demand for Money B. The Supply of Money C. Money and Interest Rates How Credit Matters: A First Approximation Money, Credit, and the Economy Are Money and Credit All That Matter? A. Money and Credit Flows: First Fiddle or Second Fiddle? Answers to Review Questions Briefly define the interest rate, reserves, the required reserve ratio, the inflation rate, and nominal GDP. Interest Rate: The cost to borrowers of obtaining money and the return (or yield) of money to lenders. Reserves: Assets that are held by depository institutions as either vault cash or reserve deposit accounts with the Fed. Required Reserve Ratio: Depository institutions must have reserve assets equal to a certain percentage of deposit liabilities; the required reserve ratio is that percentage. The Inflation Rate: The rate of change of a price index, such as the consumer price index. Nominal GDP: The quantity of final goods and services produced in an economy during a given time period and valued at today’s prices. 12 The Role of Money and Credit 13 Discuss the similarities between how the price of compact discs is determined in the compact disc market and how the interest rate is determined in the market for money. The price of compact discs is determined by the demand and supply of compact discs in the market for compact discs. The interest rate (the price of borrowing or lending money) is determined by the supply and demand for money in the market for money. In both cases, the price is determined by the factors affecting the supply and demand of each item. What is the difference between the demand for money and the quantity demanded of money? The demand for money is amount of money that will be demanded at various interest rates. In other words, it is the entire set of interest rate -quantity demanded combinations as represented by a downward-sloping demand curve. The quantity demanded of money is the amount that will be deman ded by spending units at a specific interest rate. When the interest rate changes, the quantity demanded of money changes. The interest rate and the quantity demanded are inversely related. What is the opportunity cost of holding money? The opportunity cost of holding money is the value of the next best alternative to holding money. This is the interest that could be earned by holding non -monetary assets. Chris and Harold Yoshida are a young couple with a growing income. What will happen to their demand for money over time? Since income is directly (positively) related to the demand for money, as the Yoshida’s income grows over time, their demand for money will also grow. In what form can a depository institution hold reserves? Who determines the amount o f funds available for reserves? How does the Fed influence the amount of reserves a depository institution must hold? A depository institution can hold reserves as either vault cash or reserve deposit accounts with the Fed. The Fed determines the amount of cash assets outstanding and hence the amount available for reserves. The Fed influences the amount of reserves assets a depository institution must hold by setting the required reserve ratio. What are the sources of credit? Explain the following statement : “The money supply is measured at a point in time while the flow of credit is measured over time.” Credit comes from depository institutions, other financial intermediaries, and other financial and nonfinancial institutions. The money supply is a stock, w hile credit is a flow. Flows over time lead to changes in stocks measured at different points in time. Likewise, changes in stocks measured at different points in time result from flows over time. How does real GDP differ from nominal GDP? Real GDP is the inflation adjusted quantity of final goods and services produced in an economy in a given time period. Nominal GDP is the quantity of final goods and services produced in an economy during a given time period and valued at today’s prices. 14 Chapter 3 Alarm clocks going off and sunrise are highly correlated. Does the sound of alarm clocks going off cause the run to rise? Why or why not? Alarm clocks going off obviously do not cause the sun to rise. To assume so would be mistaking correlation (association) with causation. Explain the difference between money and credit. Give an example of each. Money is anything that functions as a means of payment, unit of account, and store of value. Credit is the flow of money in a given time period from SSUs or financial intermediari es to DSUs. Currency is money whereas a loan is credit. Answers to Analytical Questions Show on a graph how the interest rate and the quantity demanded of money are related. Do the same for the quantity supplied of money. When is the market in equilibri um? The demand curve of the graph above shows that the interest rate and the quantity demanded of money are inversely related. The supply curve of the graph above also shows that any given supply of moneyas determined by the Fedis independent of the interest rate. The market is in equilibrium at the interest rate where the supply curve (S) and the demand curve (D) intersect. That is, at the interest rate where the quantity demanded of money is equal to the quantity supplied. Assume the market for money is originally in equilibrium. Explain what happens to demand, supply, quantity demanded, and/or quantity supplied, ceteris paribus, given each of the following events: a. b. c. d. The Fed lowers reserve requirements. Households increase their spending plans. Income falls due to a severe recession. The Fed steps up its provision of reserves to depository institutions. a. Demand for money stays the same; the supply of money increases (supply curve shifts rightward); quantity demanded increases due to the fall in interest rates; quantity supplied increases because of the rightward shift of the supply curve. The Role of Money and Credit 15 b. Demand for money increases (demand curve shifts rightward) causing the interest rate to rise; the supply of money stays the same; quantity demanded stays the same; quantity supplied stays the same. c. Demand for money decreases (demand curve shifts leftward); the supply of money stays the same; quantity demanded and quantity supplied stay the same. d. Demand for money stays the same; the supply of money increases due to the increased provision of reserves; quantity demanded and quantity supplied both increase. Graph each case presented in question 12. Graph a illustrates question 21a, where the supply curve shifts fr om S to S1. Graph 21b illustrates question 21b, where the demand curve shifts from D to D1. Graph 21c illustrates question 21c, where the demand curve shifts from D to D1. Graph 21d illustrates question 21d, where the supply curve shifts from S to S1. What are the effects of an increase in the supply of money on interest rates, prices, and output? What are the effects of a decrease in the supply of money on interest rates, prices, and output? Do these effects occur simultaneously? A rise in the money supply (rightward shift of the supply curve) causes the interest rate to fall. Lower interest rates lead to increases in interest sensitive spending and increases in aggregate demand. Increases in aggregate demand lead to increases in output. Eventually , increases in the money supply may lead to increases in the overall price level. A decrease in the money supply (leftward shift of the supply curve) will lead to opposite effects. The fall in the money supply causes interest rates to rise, and puts downw ard pressure on prices and output. In both cases, price changes occur with a lag. Substituting the words “credit flows” for “supply of money,” answer question 14. A rise in the credit flows causes the interest rate to fall. Lower interest rates lead to i ncreases in interest sensitive spending and increases in aggregate demand. Increases in aggregate 16 Chapter 3 demand lead to increases in output. Eventually, increases in credit flows may lead to increases in the overall price level. A decrease in credit flows will lead to the opposite effects. The fall in credit flows causes interest rates to rise, and puts downward pressure on prices and output. In both cases, price changes occur with a lag. What happens to interest rates, prices, and output when the demand for m oney increases? What happens to the same variables when the demand for money decreases? When the demand for money increases, the demand curve shifts rightward, and interest rates rise. The rise in interest rates chokes off some spending and reduces aggre gate demand. The fall in aggregate demand may decrease output and put downward pressure on prices. The reverse happens when the demand for money decreases. Namely, interest rates fall, aggregate demand picks up, and there is upward pressure on prices. Substituting the words “credit flows” for “demand for money,” answer question 16. When credit flows increase, the demand for credit increases, and interest rates rise. The rise in interest rates chokes off some spending and reduces aggregate demand. The f all in aggregate demand may decrease output and put downward pressure on prices. The reverse happens when credit flows decrease. Namely, interest rates fall, aggregate demand picks up, and there is upward pressure on prices. Assume that the price of a market basket of goods and services is $2,000 in the base period, $2,060 one year later, and $2,100 two years later. What is the price index in the base period? After the first year? After the second year? What is the rate of inflation in the first year? In the second year? The price index is always 100 in the base year. After the first year, the price index is 103 ($2,060/$2,000 x 100). The price index the second year is 105 ($2,100/$2,000 x 100). The rate of inflation the first year is 3 percent ((1 03 – 100)/100). The rate of inflation the second year is 1.99 percent ((105-103)/103). Ceteris paribus, what happens to the demand for money if incomes go down? Ceteris paribus, what happens to the supply of money if reserves go up? In each case, does the interest rate change? Graph each case. If incomes go down, the demand for money decreases (Case 1) and interest rates fall. If reserves go up, the supply of money increases (Case 11) and the interest rate falls. The Role of Money and Credit 17 Use a graph to show what happens to the interest rate if the demand for money is increasing while the supply of money is decreasing. The graph above shows what happens to the interest rate when the demand for money is increasing and the supply of money decreasing. Originally, the market is in equilibrium where the demand curve (D) and the supply curve (S) intersect at interest rate i. At equilibrium, the quantity supplied of money is equal to the quantity demanded. When the demand for money increases from D to D1, and the supply of money decreases from S to S1, the market will move to the intersection of the new demand and supply curve. The interest rate increases to i1. Assume a price index increases from 145 to 150 to 155 over three consecutive years. Was the rate of inflation higher in the second or third year? What does it mean when a price index falls from 150 to 145? In the first year, the rate of inflation was 3.1 percent ((150 -145)/145). In the second year, the rate of inflation was 3 percent ((155-150)/150). When a price index falls in value, it means that the overall level of prices has fallen and that there is deflation or negative inflation. In this case, the overall level of prices fell 3 percent.