Money and Banking: The behavior of interest rates

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Money and Banking The behavior of interest rates

• Spring 2007
• Martin Andreas Wurm
• University of Wisconsin - Milwaukee

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The behavior of interest rates

• 5. The Liquidity Preference Framework
• Other than the loanable funds framework there
  exists another instrument to analyze interest
  rates.
• This instrument has been developed out of the
  Keynesian model and is known as the Liquidity
  Preference Framework
• When Keynes wrote his General Theory of
  Employment, Interest and Money in 1935 he made
  the simplifying assumption that individuals could
  hold their wealth only in two forms of assets

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The behavior of interest rates

• 5. The Liquidity Preference Framework
• Bonds B and Money (Cash) M.
• Note, that the amount of bonds and money demanded
  in an economy must, thus, equal total wealth in
  that economy.
• In equilibrium the quantity of bonds and money
  held in an economy must, then, equal their supply

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The behavior of interest rates

• 5. The Liquidity Preference Framework
• The second equation above tells us something
  about equilibrium in bonds and money markets
• If the supply of bonds is equal to the demand for
  bonds, the right hand side of this equation is
  equal to zero.
• As a consequence the second market must clear,
  too, since the left hand side of this equation
  must be zero as well in equilibrium (this is
  known as Walras Law)

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The behavior of interest rates

• 5. The Liquidity Preference Framework
• Thus, the equilibrium interest rate in the bonds
  market is also the one at which the money market
  is in equilibrium!
• We can, therefore, use demand and supply in the
  (nominal) money market to analyze changes in the
  interest rate.
• This is especially helpful when we try to analyze
  shifts in money supply and inflation.

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The behavior of interest rates

• 5. The Liquidity Preference Framework
• The key argument here is that holding money earns
  no interest.
• If this is the case, the interest rate on bonds
  acts as the opportunity cost of holding money,
  since every time you hold money, you forego
  interest.
• Thus, the demand for money will be negatively
  related to the interest rate on bonds (in this
  sense, the interest rate is the price of money)
  as demonstrated in the following graph.

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The behavior of interest rates

• 5. The Liquidity Preference Framework

i
i0
i1
M
Md1
Md0
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The behavior of interest rates

• 5. The Liquidity Preference Framework
• The supply of money is assumed to be exogenous,
  i.e. not determined within the model.
• In reality the Ms is set by the Federal Reserve,
  which makes this a somewhat plausible assumption.
• The important feature of this assumption is that
  Ms is not a function of the interest rate and
  can, thus, be displayed as a vertical line in our
  diagram

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The behavior of interest rates

• 5. The Liquidity Preference Framework

i
Ms
i
E
Md
M
Md Ms
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The behavior of interest rates

• 5. The Liquidity Preference Framework
• Where Ms and Md intersect the money market is in
  equilibrium.
• This point E0 corresponds to a specific
  equilibrium interest rate which will also clear
  the bonds market
• We can now use this diagram to analyze interest
  rate behavior induced by shifts in money demand
  and money supply

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The behavior of interest rates

• 5. The Liquidity Preference Framework
• 1. There are two major determinants of money
  demand
• 1. Households income determines demand for money
  for reasons of transactions
• As an individuals income increases (e.g. during
  a business cycle expansion), her or his demand
  for money will increase, since her or his
  consumption increases (et v.v.)

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The behavior of interest rates

• 5. The Liquidity Preference Framework
• There are two major determinants of money demand
• 2. Changes in the price level (in-/deflation). If
  prices rise, the real value of money declines.
• Thus, in order to keep the real purchasing power
  of money constant, individuals will want to hold
  a larger nominal amount of money in order to meet
  their transactions demand. Thus, increases in
  prices of goods c.p. lead to a higher nominal
  demand for money (keeping the real demand Md/P
  constant)

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The behavior of interest rates

• 5. The Liquidity Preference Framework
• If money demand increases for one of the two
  reasons starting from an original equilibrium E0
  in the graph below c.p. people will try to sell
  their bonds for money.
• However, the total supply of money in the economy
  has not increased! How does the market return to
  its equilibrium?

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The behavior of interest rates

• 5. The Liquidity Preference Framework
• The attempt of individuals to sell bonds will
  lower the prices at which these bonds actually
  sell and increase their interest rates.
• Since this in turn increases the opportunity cost
  of holding money, more individuals will be
  willing to hold bonds again, such that in the new
  equilibrium E1 interest rates have increased,
  such that they exactly balance both markets
  again. The aggregate quantities of money and
  bonds held have not changed!

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The behavior of interest rates

• 5. The Liquidity Preference Framework

i
Ms
E1
i1
i0
E0
Md1
Md0
M
Md0 Md1Ms
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The behavior of interest rates

• 5. The Liquidity Preference Framework
• While an increase in the demand for money leads
  to an increase in interest rates et vice versa,
  an increase in money supply decreases interest
  rates.
• The argument here (simply speaking) works through
  so called open market policies. If a central bank
  from an equilibrium E0 increases the supply of
  money it does so by buying bonds. This creates an
  excess supply of money at the old equilibrium
  interest rate and an excess demand for bonds

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The behavior of interest rates

• 5. The Liquidity Preference Framework
• The central bank decreases the supply of bonds
  driving up the prices of these bonds, which in
  turn lowers the interest rate.
• Since this reduces the opportunity cost of
  holding money, more individuals will be willing
  to hold money again
• This process is stopped once a new equilibrium E1
  is reached. at which the additional money in
  circulation is held by households

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The behavior of interest rates

• 5. The Liquidity Preference Framework

i
Ms0
Ms1
E0
i0
E1
i1
Md1
Md0
M
Md Ms1
Md Ms0
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The behavior of interest rates

• 5.The Liquidity Preference Framework
• Further, low interest rates are associated with
  high investment levels, which in turn are
  associated with higher economic growth and
  well-being.
• In the aftermath of the Keynesian revolution it
  was common wisdom for a while to use increases in
  money supply as a policy tool to fight off
  recessions.
• However, early critique of this approach was
  brought forward by Milton Friedman and this
  years nobel prize winner Edmund Phelps.

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The behavior of interest rates

• 6. Changes in the Money Supply and its Effect on
  Interest Rates
• The very short-run effect of an increase in the
  money supply is a decrease in the interest rate
  given money demand is the same.
• However, as pointed out by Milton Friedman1, the
  effectiveness of monetary policy is limited since
  there are also secondary effects on money demand.
• Other than the primary decrease in interest
  rates, which he called liquidity effect, there
  are income, price level and expected inflation
  effects if the money supply is increased.

1 Friedman, Milton, The Role of Monetary
Policy, in AER, 1968, available through the
university servers under http//www.jstor.org/vie
w/00028282/di950399/95p01092/0
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The behavior of interest rates

• 6. Changes in the Money Supply and its Effect on
  Interest Rates
• One by one
• Income effect Increases in Ms increase national
  income and, thus increase Md - leading to an
  increase in i
• Price level effect An increase in Ms increases
  prices at least in the medium run (see the AS-AD
  framework), which in turn will lead to increases
  of Md and i
• Finally, expected increases in Ms may lead to
  higher expected inflation, which in turn will
  lead to a lower demand for and higher supply of
  bonds and, thus, to an increase in i.

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The behavior of interest rates

• 6. Changes in the Money Supply and its Effect on
  Interest Rates
• To summarize
• An increase in the money supply leads to a
  decrease in i, the so called liquidity effect
• An increase in the money supply leads to shifts
  in money demand through the income, price level
  and expected inflation effects all of which
  increase i.
• Which effect is stronger is an empirical
  question, but an increase in the money supply
  might very well increase interest rates! (see the
  figures below).

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The behavior of interest rates

• 6. Changes in the Money Supply and its Effect on
  Interest Rates

i
Ms0
Ms1
E2
i2
II
i0
E0
E1
i1
I
Md1
Md0
M
Md Ms1
Md Ms0
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The behavior of interest rates

• 6. Changes in the Money Supply and its Effect on
  Interest Rates

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The behavior of interest rates

• 6. Changes in the Money Supply and its Effect on
  Interest Rates
• Some empirical evidence
• Milton Friedman and Ann Schwartz in their epochal
  research A monetary history of the United
  States (1963) have argued, that booms are
  typically preceded by increases in the money
  supply, while recessions are typically preceded
  by decreases in the money supply.
• From this observation they concluded that money
  leads output and, hence, that there exists at
  least some (although limited) room for the Fed to
  affect growth through changes in the money supply.

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The behavior of interest rates

• 6. Changes in the Money Supply and its Effect on
  Interest Rates
• Some empirical evidence
• In the 1980 this hypothesis was put to test once
  more by an econometrician named Christopher Sims.
• Sims wrote a paper titled Macroeconomics and
  Reality published in Econometrica in which he
  argued that much of the logic of the Monetarism
  vs. Keynesianism debate made unrealistic
  assumptions about which factors are exogenous
  policy variables and which ones are not.

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The behavior of interest rates

• 6. Changes in the Money Supply and its Effect on
  Interest Rates
• Some empirical evidence
• Using a newly developed statistical technique he
  made a convincing point that the money supply
  does neither very strongly affect output growth
  nor interest rates.
• In fact, his evidence suggests that the Fed (and
  the same is likely for other central banks) sets
  the money supply passively as a reaction to
  macroeconomic variables it observes (most likely
  according to inflation, output and/or interest
  rates).