Money, Interest Rates and Economic Activity

1
Money, Interest Rates and Economic Activity

• Lecture 13

2
Overview

• Present Value, Market Price and Interest Rates on
  Bonds
• Demand for Money
• Monetary Equilibrium
• Monetary Transmission Mechanism
• Short Run Non-Neutrality of Money

3
Present Value and Market Price
The present value of an asset is the highest
price someone would be willing to pay now to own
the future stream of payments delivered by the
asset.
At any price lower than the present value, there
would be excess demand for the asset this would
drive up the assets price.
Therefore, the equilibrium market price of an
asset will be the present value of the income
stream that the asset produces.
4
Present Value and the Interest Rate
Present value is the value now of one or more
payments or receipts made in the future often
referred to as the discounted present value.
Consider an asset that pays 100 in one years
time. If the interest rate is 6 per year, the
present value of the asset equals PV
100/(1.06) 94.33
The present value of any asset that yields a
given stream of payment over time is negatively
related to the interest rate.
5
If the interest rate decreases to 5, then the
present value of 100 a year from now is PV
100/(1.05) 95.24
If the interest rate increases to 7, then the
present value of 100 a year from now is PV
100/(1.07) 93.46
6
A Sequence of Future Payments Suppose a 1000
bond pays a coupon of 10 at the end of each of
three years. How much is the bond currently worth
if the interest rate is 7 percent?
PV 100 100 1100 1.07
(1.07)2 (1.07)3
We can write a more general version of this
formula that applies to any interest rate,
coupon, initial investment and number of periods.
PV R1 R2 ... RT (1i)
(1i)2 (1i)T
Where R is the coupon paid, i is the interest
rate, and T is the time period.
7
Interest Rates and Bond Prices
The preceding discussion leads us to an important
propositions, stressing the negative relationship
between interest rates and asset prices.
The market interest rate is negatively related to
the price of a bond.
8
The Demand for Money
Reasons for Holding Money
The amount of money balances that everyone in the
economy wishes to hold is called the demand for
money.
The opportunity cost of holding any money balance
is the interest that could have been earned if
the money had been used instead to purchase bonds.
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There are three motives for holding money

• the transactions motive,
• the precautionary motive, and
• the speculative motive.

Transactions balances are money balances held in
order to finance payments because payments and
receipts are not perfectly synchronized.
Precautionary balances are money balances held in
order to protect against uncertainty of the
timing of cash flows.
Speculative balances are money balances held as a
hedge against the uncertainty of the prices of
financial assets especially bonds.
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Determinants of Money Demand

• An increase in the interest rate increases the
  opportunity cost of holding money and leads to a
  reduction in the quantity of money demanded.
• An increase in the level of real GDP increases
  the volume of transactions and leads to an
  increase in the quantity of money demanded.
• An increases in the price level increases the
  dollar value of a given volume of transactions
  and leads to an increase in the quantity of money
  demanded.

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Liquidity Preference Function
i
Economists refer to the money demand function as
the liquidity preference function.
i1

- MD MD (i, Y, P)
i0

MD
The function relating money demanded to the rate
of interest is called the money demand curve (MD).
M0
M1
Quantity of Money
Changes in the level of real GDP or in the price
level will shift the liquidity preference
function, while changes in the interest are
reflected as movements along the curve.
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Monetary Equilibrium
Monetary equilibrium occurs when the quantity of
money demanded equals the quantity of money
supplied.
Interest Rate
MS
excess supply of money

i2
excess demand for money
The interest rate falls when there is excess
supply of money.
i0

i1

MD
M1
M0
M2
The interest rate rises when there is an excess
demand for money.
Quantity of Money
13
The Monetary Transmission Mechanism
The mechanism by which changes in the supply and
demand for money affect aggregate demand is
called the transmission mechanism.
The transmission mechanism operates in three
stages
1. A change in money demand or supply changes the
equilibrium interest rate. 2. The change in the
interest rate leads to a change in desired
investment expenditure. 3. The change in desired
investment expenditure leads to a change in
aggregate demand.
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Interest Rate
Interest Rate
MS0
MS1
MS
Increase in money demand
i2

Increase in money supply
i0

i0

MD1
i1

MD
MD0
M0
M1
M0
Quantity of Money
Quantity of Money
Part 1. Shifts in the supply of money or the
demand for money cause the equilibrium interest
rate to change.
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Interest Rate
Interest Rate
MS0
MS1
i0
i0


i1
i1


MD
ID
I1
M0
M1
I0
Desired Investment Expenditure
Quantity of Money
Part 2. Changes in the equilibrium interest rate
lead to changes in desired investment
expenditure. (In this case, the interest rate
changes because of a change in money supply.)
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AE1
E1
AE

Part 3. Changes in desired investment
expenditure lead to a shift in the AE function,
and therefore a shift in the AD curve.
AE0

?I
E0
Y
Y1
Y0
P
In this case, we illustrate an increase in
desired investment and thus a rightward shift in
the AD curve.
P0


AD1
AD0
Y0
Y1
Y
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An Open-Economy Modification

• In an open economy with mobile financial capital,
  there is an extra part to the transmission
  mechanism.
• As interest rates change domestically, financial
  capital flows between countries, putting pressure
  on the exchange rate.
• As the exchange rate changes, exports and imports
  then change, adding to the effect on aggregate
  demand.

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The Long Run Neutrality of Money
A shift in the AD curve will lead to different
effects in the short run than in the long run.
In the long run, output eventually returns to
potential output following a shock.
As a result, although a change in the money
supply causes the AD curve to shift, it has no
effect on the long-run level of GDP. The belief
that changes in the money supply do not have
long-run effects is referred to as long-run money
neutrality.
The Classical Dichotomy refers to the view that
changes in money supply affect only the price
level, but do not affect real variables.
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AS1
MS0
MS1
Interest Rate
Price Level
AS0
E0

E2
P2

E2

i0

P1
E1

i1
AD1
P0

E1
MD2
E0

I1
AD0
MD1
MD0
Y1
Y
Quantity of Money
Real GDP
Although a change in the money supply causes the
AD curve to shift, it has no effect on the level
of real GDP in the long run. (Nor does it affect
any other real variable in the long run.)
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Short Run Non-Neutrality of Money
There is less debate regarding the short-run
effects of money. For a given AS curve, the
short-run effect of a change in the money supply
on real GDP and the price level is determined by
the extent of the shift of the AD curve.
There is debate, however, regarding how effective
policies that stimulate aggregate demand are.
Monetarists hold the view that monetary policy is
a very effective tool for stimulating aggregate
demand.
The effectiveness of monetary policy in the short
run depends on the slopes of the Money Demand
(MD) and the Investment Demand (ID) curves. The
steeper the MD curve and the flatter the ID
curve, the more effective is monetary policy.
21
In the 1950s and 1960s, there was an important
debate about the strength of monetary forces. The
debate centered around the slopes of the MD and
ID curves.
Keynesians argued that MD was relatively flat and
ID was relatively steep. As a result, they argued
that monetary policy was not very effective.
Monetarists argued that MD was relatively steep
and that ID was relatively flat. As a result,
monetary policy was quite effective.
Most empirical evidence points to a steep MD
curve, but is inconclusive about the slope of the
ID curve.
22
The effectiveness of monetary policy will depend
on the slopes of the money demand (MD) and
investment demand (ID) curves.
i
i
Flat Investment Demand
Steep Money Demand
Investment
Quantity of Money
Changes in money supply are effective
23
If money demand is fairly flat or investment
demand is fairly steep, changes in money supply
will not stimulate significant changes in
investment.
i
i
Flat Money Demand
Steep Investment Demand
Investment
Quantity of Money
Changes in money supply are not effective
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Summary
There is a negative relationship between the
price of a financial asset and its interest rate
(and its yield).
MS
i
Interest rates are determined in the short run
through the interaction of money supply and money
demand.
i
MD
Quantity of Money
25
An increase in the money supply causes the
equilibrium interest rate to fall.
The excess supply of money puts downward pressure
on interest rates.
MS0
MS1
i
Excess Supply
i0
i1
MD
M0 M1
Quantity of Money
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Interest Rate
Interest Rate
MS0
MS1
i0
i0


i1
i1


MD
ID
I1
M0
M1
I0
Desired Investment Expenditure
Quantity of Money
A fall in the interest rate leads to an increase
in investment demand.
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Lower domestic interest rates make domestic
financial assets less attractive. As a result,
capital flows out of the economy as people
substitute domestic assets for foreign assets.
This increases the demand for foreign currency
and lowers the demand for the domestic currency.
The countrys currency depreciates.
When a countrys currency depreciates, its
exports become less expensive to foreigners and
its imports become more expensive to residents.
The fall in interest rates ultimately leads to an
increase in NET EXPORTS (NX).