Chapter 9: Money, The Price Level, and Interest Rates

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Chapter 9 Money, The Price Level, and
Interest Rates
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Circular Flow Diagram
Flow of dollars
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Money and the Price Level

• Equation of Exchange MV ? PQ
• The money supply (M) multiplied by its Velocity
  (V) must be equal to the price level (P) times
  Real GDP (Q).
• Velocity the average number of times a dollar
  is spent to buy final goods and services in a
  year.

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The Equation of Exchange

• In a large economy, it is impossible to count how
  many times each dollar has changed hands.
• Velocity must be equal to GDP divided by the
  average money supply.
• VNominal GDP/Money supply
• VGDP/M (in the textbook)
• Nominal GDP is equal to PxQ, where Q is the
  quantity of GDP produced in the economy and is
  measured by Real GDP.

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Interpreting the Equation of Exchange

• V(PxQ)/M ? MVPxQ
• The money supply multiplied by velocity must
  equal the price level times Real GDP M x V ? P x
  Q
• The money supply multiplied by velocity must
  equal Nominal GDP M x V ? NGDP
• Total spending or expenditures (measured by MV)
  must equal the total sales revenues of business
  firms (measured by PQ) MV ? PQ

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Interpreting the Equation of Exchange

• Equation of Exchange
• MxVPxQ
• M Money Supply
• V Velocity
• P Price Level (GDP deflator or CPI)
• Q Real GDP
• PxQ Nominal GDP

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From the Equation of Exchange to the Simple
Quantity Theory of Money

• Fisher and Marshall assumed changes in velocity
  are so small that for all practical purposes
  velocity can be assumed to be constant.
• Fisher and Marshall assumed Real GDP is fixed in
  the short run.
• From these assumptions, we have the simple
  quantity theory of money changes in M will bring
  about proportional changes in P.

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From the Equation of Exchange to the Simple
Quantity Theory of Money
Notation ? means change
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Exhibit 1 Assumptions and Predictions of the
Simple Quantity Theory of Money
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Exhibit 1 Assumptions and Predictions of the
Simple Quantity Theory of Money
change in M or ?M is calculated as follows
Same is true for P change in P or ?P is
calculated as follows
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The Simple Quantity Theory in an AD-AS Framework

• MV is equal to Total Expenditures (AD).
• Total expenditures is equal to
• CIG(EX-IM)
• Since MVTE, MVCIG(EX-IM)
• A change in the money supply or a change in
  velocity will change aggregate demand and
  therefore lead to a shift in the AD curve.
• In the simple quantity theory of money, velocity
  is assumed to be constant.

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Exhibit 3 The Simple Quantity Theory in an
AD-AS Framework
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Dropping the Assumptions that V and Q are Constant

• Remember M x V ? P x Q, then
• P M x V
• Q
• Money supply, velocity, and Real GDP determine
  the Price Level.
• An increase in M or V or a decrease in Q will
  cause prices to rise. This is inflation.
• A decrease in M or V or an increase in Q will
  cause prices to fall. This is deflation.

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Self-Test

• If M times V increases, why does P times Q have
  to rise?
• What is the difference between the equation of
  exchange and the simple quantity theory of money?
• Predict what will happen to the AD curve as a
  result of each of the following
• The money supply rises, velocity is unchanged
• Velocity falls, MS is unchanged
• The money supply rises by a greater percentage
  than velocity falls
• The money supply falls, velocity is unchanged.

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Monetarism Key Views

• Velocity changes in a predictable way.
• Aggregate Demand depends on the money supply and
  on Velocity.
• The SRAS curve is upward sloping.
• The Economy is Self-Regulating (Prices and Wages
  are flexible)

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Exhibit 4 Monetarism in an AD-AS Framework
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The Monetarist View of the Economy

• The economy is self-regulating
• Changes in velocity and the money supply can
  change aggregate demand.
• Changes in velocity and the money supply will
  change the price level and Real GDP in the short
  run, but only the price level in the long run.

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The Monetarist View of the Economy

• Changes in velocity are not likely to offset
  changes in the money supply.
• Changes in the money supply will largely
  determine changes in aggregate demand, and
  therefore changes in Real GDP and the price
  level.
• An increase in the money supply will raise
  aggregate demand and increase both Real GDP and
  the price level in the short run and increase the
  price level in the long run.
• A decrease in the money supply will lower
  aggregate demand and decrease both Real GDP and
  price level in the short run and decrease price
  level in the long run.

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Self-Test

• What do monetarists predict will happen in the
  short run and in the long run as a result of each
  of the following
• Velocity rises
• Velocity falls
• The money supply rises
• The money supply falls.
• Can a change in velocity offset a change in the
  money supply (on aggregate demand)? Explain your
  answer.

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Money and Interest Rates What economic variables
are affected by a change in the money supply?

• The supply of loans.
• Real GDP
• The price level
• The expected inflation rate.

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Money and Interest Rates

• A change in the money supply creates a change in
  interest rates due to a change in
• Liquidity Effect the supply of loanable funds.
• Income Effect Real GDP.
• Price Level Effect the price level.
• Expectations Effect the expected inflation
  rate.

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Money and Interest Rates

• Liquidity Effect The change in the interest
  rate due to a change in the supply of loanable
  funds.
• Money supply increase, increases reserves in the
  banks and shifts to the right supply of loanable
  funds. Interest rate declines.
• Income Effect Change in interest rate due to
  the change in Real GDP.
• Money supply increase, shifts AD to right
  increasing Real GDP. Real GDP increase increases
  both the supply and demand of loanable funds.
  Demand usually increases more than supply
  resulting in increase of interest rate.

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Money and Interest Rates

• Price Level Effect The change in the interest
  rate due to a change in price level.
• Increase in money supply shifts AD to right
  increasing price level. Increase in price level
  decreases purchasing power of money. As a result
  people increase demand for loanable funds.
  Interest rate goes up.
• Expectations Effect The change in interest rate
  due to a change in the expected inflation rate.
• When Fed announces increase in money supply
  people will expect increase in price level. Thus
  they expect inflation rate to increase. It will
  increase demand for loanable funds and decrease
  supply of loanable funds and will increase
  interest rate.

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Exhibit 5 The Interest Rate and the Loanable
Funds Market
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Exhibit 6 How the Fed Affects the Interest Rate
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What Happens to the Interest Rate as the Money
Supply Changes?

• Change in Money Supply changes
• Supply of loanable funds
• Real GDP
• The price level
• Expected Inflation
• Net impact on Interest Rate dependent on
• Timing
• Magnitudes

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The Nominal and Real Interest Rates

• Nominal interest rate the interest rate
  actually charged (or paid) in the market the
  market interest rate.
• The Real Interest Rate the Nominal Interest
  Rate minus the Expected Inflation Rate.
• Real interest rateNominal interest rate
  Expected Inflation rate
• or
• Nominal interest rateReal interest rate
  Expected Inflation rate

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Self-Test

• If the expected inflation rate is 4 and the
  nominal interest rate is 7, what is the real
  interest rate?
• Is it possible for the nominal interest rate to
  immediately rise following an increase in the
  money supply? Explain your answer.
• The Fed only affects the interest rate via the
  liquidity effect. Do you agree or disagree?
  Explain your answer.