Fed Policy and Money Markets

1
TOPIC 5

• Fed Policy and Money Markets

2
Outline

• What is Money?
• What affects the supply of money?
• How the banking system works?
• What is the Fed and how does it work?
• What is a monetary policy?
• What does affect the demand of money?
• Asset Portfolio Decision
• Quantitative Theory of Money
• Equilibrium in the Money Market
• The LM curve

3

• Overview of Money and The Banking System

4
Money

• Money is the economic term for assets that are
  widely used and accepted as payment.
• The forms of money have been very different from
  shells to gold to cigarettes
• (Eastern Europe and German Prisoners Of War
  camps)
• Most prices are measured in units of money ?
  understanding the role of money is important to
  understanding inflation.
• Many economists believe that money also has an
  impact on real variables (mostly in the short
  run)

5
Three Functions of Money

• Medium of exchange Money permits trade of goods
  and services at lower cost (in terms of time and
  effort)
• Barter is inefficient because it is difficult and
  time-consuming to find a trading partner.
• Other benefit allows specialization (and
  increases productivity)
• Unit of account Money is the basic unit for
  measuring economic value
• Given that goods and services are mostly
  exchanged for money, it is natural to express
  economic value in terms of money
• Caveat In countries with volatile inflation,
  money is a poor unit of account because prices
  must be changed frequently. More stable units of
  account like dollars or gold are used even if
  transactions use local currency.
• Store of Value money is a way of storing wealth.
  
• Other types of assets may pay higher returns, BUT
  money is also a medium of exchange.

6
Measures of Money

• The distinction between monetary and non-monetary
  assets is controversial.
• Example MMMFs (money market mutual funds) are
  organizations that sell shares to the public and
  invest in short-term government and corporate
  debt. MMMFs pay low return and allow for checking
  (with fees)Are they Money?
• There are two main official measures of money
  stock, called monetary aggregates
• M1 the most narrow definition, includes mainly
  currencies and balances held in checking
  accounts.
• M2 includes everything in M1 plus other money
  like components saving deposits, small time
  deposits, MMMFs, MMDAs (money market deposit
  accounts), etc..

7
Money Supply

• Money supply is the amount of money available in
  an economy
• In modern economies, money supply is affected by
• Central Banks (the Federal Reserve System in the
  United States). The central bank is a government
  institution responsible for monetary policies
  within an economy. See readings 51, 52
• Depositary Institutions. Deposit Institutions
  are privately owned banks and thrift institutions
  that accept deposits from and make loans directly
  to the public.
• The public. The public includes every person or
  firm (except banks) that holds money in currency
  or deposits (think of money in your pocket or
  money in your firms petty cash drawer).

8
The Banking System An Introduction

• Bank Assets and Liabilities
• Assets Loans (TL) Reserves (TR)
• Liabilities Deposits (TD) (and potentially
  other stuff).
• Reserves liquid assets held by the bank to
  meet the demand for
• withdrawals by depositors or to pay
  checks
• How do banks make money? They Lend.
• How much do they lend? Must keep a minimum
  amount of reserves (required by law).
• Definition m required reserve ratio

9
The Banking System An Introduction

• Fractional reserve banking Banks hold only a
  fraction of their deposits in reserve.
• Reserve-deposit ratio required
  reserves/deposits m
• Fractional reserve banking ? m lt 1 (100
  reserve banking ? m 1)
• Assume banks lend all they can
• - TR mTD
• - Implies banks only hold required reserves
• Implications
• - TD TL TR (money held within the
  banking system)
• - ?TD ?TL ?TR (equation holds in changes)

10
The Banking System An Example

• Suppose I put 500 in the bank (remove it from
  under my mattress).
• We call the 500 that starts the process the
  Initial Deposit (ID)
• Two Strong Assumptions 1) Suppose that no one
  else in the economy holds cash.
• 2) Suppose banks only hold required
  reserves.
• Minor Assumption Suppose that m 0.1.
• What happens in the banking system
• Step 1 Deposits increase by 500 (initial
  deposit).
• Step 2 Then, Deposits increase by another
  450.
• Step 3 Then, Deposits increase by another
  405.
• Step 4 .(keep increasing)
• Step infinity .(keep increasing)
• Why do deposits keep increasing? LOANS!!!!

11
The Banking System An Example

• Step 1 Assets Liabilities
• TR 500 TD 500
• TRr .1500 50 ? ?TL TR TRr 450
• Step 2 Assets Liabilities
• TR 500 TD 950
• TL 450
• TRr .1950 95 ? ?TL TR TRr 405
• Step 3 Assets Liabilities
• TR 500 TD 1355
• TL 855
• TRr .1 1355 135.5 ? ?TL TR TRr 364.5
• The process continues .. Loans and deposits
  expand up to a point TRr (required reserves) TR
  (actual reserves).

12
The Money Multiplier Formula Intuition

• Total Change in Deposits ID ID (1-m)
  ID(1-m)2
• ID (1 (1-m) (1-m)2 )
• ID (1/m)
• Simple Money Multiplier µm 1/m
• TD (1/m) ID
• I want to stress that above equation only holds
  if
• There are no holding of currency out of the
  banking system
• Banks may only hold required reserves

13
A More Realist Model Money Supply and Monetary
Base

• More Definitions
• MS Money Supply
• TC Total Currency in Circulation (held
  outside banking system)
• BASE Monetary base
• Some Formulas
• MS TC TD (Money money held in banks
  money held outside banks)
• ?MS ?TC ?TD (Equation holds in changes)
• ?MS ?TC ?TR ?TL (Substitute in change ?TD
  ?TR ?TL)
• BASE TC TR (All the physical currency in
  the economy)
• Base actual currency in the economy (held in
  the banks as reserves or held by the public
  outside the banking system)

14
Money Supply and Monetary Base

• Combining the two definitions (for MS and Base)
  we get
• MS/BASE (TC TD) / (TC TR)
• Define TC/TD cu currency/deposit ratio.
• Depends on the amount of money the public
  wants to hold as currency vs deposits.
• The public can increases or reduces cu, by
  withdrawing or depositing currency
• Recall TR/TD reserves/deposits ratio determined
  by the banks regulation
• (Define m actual reserve ratio held by banks
  such that m m )
• With some algebra, we can re-write the Money
  supply as
• MS (cu 1)/(cu m) BASE

15
More Generally.

• Remember MS (cu 1)/(cu m) BASE
• If cu gt 0 and m gt m, the money multiplier can be
  expressed as
• µm (cu 1)/(cu m)
• - µm gt 1 as long as m lt 1!
• - The Money multiplier decreases with cu!
  Role of the public
• - The Money multiplier decreases with m!
  Role of the banks
• Holding the base constant, the money supply (MS)
  will fall if people prefer holding cash outside
  of banking system (cu increases) or if banks
  start holding excess reserves (m increases above
  m).
• See Supplemental Notes 9

16

• Overview of The Federal Reserve

17
What is the Fed?

• Overview
• Quasi Public agency that oversees the U.S.
  banking system.
• For the most part, independent of Executive and
  Legislative branches.
• See reading 66
• 7 of the governing members (Governors) at the Fed
  are Presidential Appointments with Senate
  Confirmation (like Supreme Court Justices).
• Has its own budget
• 12 member governing board the 7 above members
  plus 5 rotating members from the Federal reserve
  branch banks (privately owned).
• See Supplemental Notes 8 for more detail

18
What Part of the Money Supply Is Controlled by
Fed?

• Remember (from previous slide)
• MS (cu 1)/(cu m) BASE
• Fed controls
• Base
• m (by law - the required reserve ratio)
• m (by influencing the discount rate and other
  policies)
• Fed does not perfectly control the money supply
  any time
• cu gt 0 (some people hold currency outside of
  banking system)
• m gt m (banks hold excess reserves)
• If cu 0 and m m, MS Base/m
  Base µm TR µm

19
How Does the Fed Control Money Supply?

• How can the Fed affect money supply (and thereby
  interest rates)?
• By creating reserves.
• a) Open Market Operations (change the
  monetary base directly)
• b) Reserve Ratio (not used very much
  change the money multiplier)
• c) Discount Window (discount rate change
  the money multiplier)
• d) Paying Interest on Excess Reserves
  (change the money multiplier!)
• e) New Instruments (TARP, etc. increase
  the money multiplier/base)
• Note The discount rate/new instruments could
  increase the money supply by inducing banks to
  hold less excess reserves (by brining m close
  to m).

20
Notes on Central Banks

• The Central Bank is The Banks Bank. The
  Central Bank operates a clearinghouse for bank
  checks. Each member bank has an account with the
  Central Bank. In the U.S. the deposits that
  banks have with the Fed are called federal funds.
• A closely related term, which is not specific to
  the U.S., is banks reserves (which consist of
  federal funds plus vault cash, or currency in
  the bank s cash machines, teller drawers, and
  vault).
• A check written against private bank A and
  deposited with private bank B reduces bank As
  federal funds and increases bank Bs federal
  funds. Thus banks want federal funds so they can
  honor check withdrawals. They want vault cash to
  honor cash withdrawals. Upshot banks need
  reserves to honor withdrawals.
• Neither the Fed nor other major Central Banks
  target growth rates of the money supply (which
  consists of currency plus various measures of
  liquid assets like deposits).
• Fed targets the Federal Funds rate.

21
What is the federal funds rate?

• Federal funds are the deposits of private banks
  with the Fed.
• The federal funds market consists of private
  banks borrowing and lending their federal funds
  amongst each other overnight.
• The federal funds rate is the interest rate on
  these overnight loans. It is set by supply and
  demand, not by the Fed.
• The Fed can change the supply of federal funds
  through open market operations, exerting a
  powerful indirect effect on the fed funds rate.
• The Fed targets the federal funds rate and
  carries out open market operations to keep the
  actual rate near the target rate.

22
What are Open Market Operations?
Open market operations Central Bank purchases
and sale of government securities on the open
market.
Open market purchase (sale) Central Bank
purchases (sells) government securities. The
seller (buyer) receives (uses) federal funds as
payment.
federal funds

reserves
Private Banks
Central Bank
Government Bonds
23
A Fed purchase of government securities

• Raises the supply of federal funds. More federal
  funds means they are cheaper to borrow, so a
  lower federal funds rate. (An increase in the
  supply of federal funds lowers their price)
• Drives up the price of those securities, which
  lowers their yield. A lower yield means a lower
  interest rate on government securities
• Leaves banks flush with reserves. Banks find it
  profitable to convert some of their new
  zero-interest-earning reserves into loans (which
  in turn creates more deposits, raising the money
  supply). To get people/firms to borrow more
  (take the new loans they are offering), banks
  lower the interest rate on the loans.
• Bottom Line A Fed purchase of government
  securities lowers i.

24
Notes on FOMC directives

• The Federal Reserve Open Market Committee (FOMC)
  meets every 6 weeks and issues a directive to the
  trading desk of the Federal Reserve Bank of New
  York.
• Fed Time the Desk carries out open market
  operations between 1130 and 1145 ET each
  trading day to keep the actual fed funds rate
  near the target.
• The FOMC directive is also asymmetric or
  symmetric
• Symmetric
• No bias. Neutral stance. Just as likely to
  raise as to lower the target next.
• Asymmetric
• A bias toward easing (more likely to lower than
  raise the target next) or a bias toward
  tightening (more likely to raise than lower the
  target next).
• The symmetry of the directive is not public until
  over 6 weeks after each meeting.
• Look at the federal funds rate futures in the WSJ
  to see what the market thinks.

25
Federal Reserves Lending

• The discount rate is the interest rate on
  direct loans from the Fed to private banks. The
  Fed sets the discount rate.
• Discount window loans used to play a minor role
  in Fed policy (primary and secondary credit
  discount loan since 2003)
• With the recent crisis, more banks have used
  discount windows loans together with new
  borrowing channels.
• New Monetary Policy instryments Term Auction
  Facility (TAF), Term Asset-Backed Securities Loan
  Facility (TALF), Commercial Paper Funding
  Facilities (CPFF),

26
Monetary Base Total reserves of depository institutions Required reserves of depository institutions Total borrowings of depository institutions Non borrowed reserves of dep. institutions
2007-12 836,432 42,701 40,932 15,430 27,271
2008-01 831,104 44,065 42,425 45,660 -1,595
2008-05 833,974 45,106 43,093 155,780 -110,674
2008-06 839,084 43,923 41,649 171,278 -127,355
2008-07 846,455 44,106 42,129 165,664 -121,558
2008-08 847,290 44,107 42,116 168,078 -123,972
2008-09 908,029 102,568 42,517 290,105 -187,537
2008-10 1,132,519 314,909 47,005 648,319 -333,410
2008-11 1,441,048 609,506 50,453 698,786 -89,280
2008-12 1,663,861 821,227 53,815 653,565 167,661
2009-1 1,700,775 858,418 60,173 563,496 294,922
2009-2 1,554,130 700,968 57,459 582,497 118,470
2009-3 1,639,588 779,954 55,315 612,111 167,843
2009-4 1,749,802 881,555 57,175 558,194 323,361
2009-5 1,770,208 901,293 57,192 525,448 375,845
2009-6 1,680,630 809,019 57,641 438,722 370,297
2009-7 1,666,249 795,568 62,560 366,961 428,607
2009-8 1,705,407 829,366 63,515 331,450 497,916
2009-9 1,801,506 922,758 62,681 306,827 615,931
2009-10 1,936,564 1,056,405 61,673 265,058 791,347
2009-11 2,018,813 1,140,488 63,200 217,307 923,181
2009-12 2,017.698 1,138,633 63,187 169,927 968,706
2011-6 2,647,237 1,666,386 77,576 13,243 1,653,143

27
Monetary Base Total reserves of depository institutions Required reserves of depository institutions Total borrowings of depository institutions Non borrowed reserves of dep. institutions
2007-12 836,432 42,701 40,932 15,430 27,271
2008-01 831,104 44,065 42,425 45,660 -1,595
2008-05 833,974 45,106 43,093 155,780 -110,674
2008-06 839,084 43,923 41,649 171,278 -127,355
2008-07 846,455 44,106 42,129 165,664 -121,558
2008-08 847,290 44,107 42,116 168,078 -123,972
2008-09 908,029 102,568 42,517 290,105 -187,537
2008-10 1,132,519 314,909 47,005 648,319 -333,410
2008-11 1,441,048 609,506 50,453 698,786 -89,280
2008-12 1,663,861 821,227 53,815 653,565 167,661
2009-1 1,700,775 858,418 60,173 563,496 294,922
2009-2 1,554,130 700,968 57,459 582,497 118,470
2009-3 1,639,588 779,954 55,315 612,111 167,843
2009-4 1,749,802 881,555 57,175 558,194 323,361
2009-5 1,770,208 901,293 57,192 525,448 375,845
2009-6 1,680,630 809,019 57,641 438,722 370,297
2009-7 1,666,249 795,568 62,560 366,961 428,607
2009-8 1,705,407 829,366 63,515 331,450 497,916
2009-9 1,801,506 922,758 62,681 306,827 615,931
2009-10 1,936,564 1,056,405 61,673 265,058 791,347
2009-11 2,018,813 1,140,488 63,200 217,307 923,181
2009-12 2,017.698 1,138,633 63,187 169,927 968,706
2011-6 2,647,237 1,666,386 77,576 13,243 1,653,143

Huge increase in excess reserves after Lehman
Failed
28
Monetary Base Total reserves of depository institutions Required reserves of depository institutions Total borrowings of depository institutions Non borrowed reserves of dep. institutions
2007-12 836,432 42,701 40,932 15,430 27,271
2008-01 831,104 44,065 42,425 45,660 -1,595
2008-05 833,974 45,106 43,093 155,780 -110,674
2008-06 839,084 43,923 41,649 171,278 -127,355
2008-07 846,455 44,106 42,129 165,664 -121,558
2008-08 847,290 44,107 42,116 168,078 -123,972
2008-09 908,029 102,568 42,517 290,105 -187,537
2008-10 1,132,519 314,909 47,005 648,319 -333,410
2008-11 1,441,048 609,506 50,453 698,786 -89,280
2008-12 1,663,861 821,227 53,815 653,565 167,661
2009-1 1,700,775 858,418 60,173 563,496 294,922
2009-2 1,554,130 700,968 57,459 582,497 118,470
2009-3 1,639,588 779,954 55,315 612,111 167,843
2009-4 1,749,802 881,555 57,175 558,194 323,361
2009-5 1,770,208 901,293 57,192 525,448 375,845
2009-6 1,680,630 809,019 57,641 438,722 370,297
2009-7 1,666,249 795,568 62,560 366,961 428,607
2009-8 1,705,407 829,366 63,515 331,450 497,916
2009-9 1,801,506 922,758 62,681 306,827 615,931
2009-10 1,936,564 1,056,405 61,673 265,058 791,347
2009-11 2,018,813 1,140,488 63,200 217,307 923,181
2009-12 2,017.698 1,138,633 63,187 169,927 968,706
2011-6 2,647,237 1,666,386 77,576 13,243 1,653,143

Why? Increase Risk and the Fed is Paying
Interest on the Debt
29
Monetary Base Total reserves of depository institutions Required reserves of depository institutions Total borrowings of depository institutions Non borrowed reserves of dep. institutions
2007-12 836,432 42,701 40,932 15,430 27,271
2008-01 831,104 44,065 42,425 45,660 -1,595
2008-05 833,974 45,106 43,093 155,780 -110,674
2008-06 839,084 43,923 41,649 171,278 -127,355
2008-07 846,455 44,106 42,129 165,664 -121,558
2008-08 847,290 44,107 42,116 168,078 -123,972
2008-09 908,029 102,568 42,517 290,105 -187,537
2008-10 1,132,519 314,909 47,005 648,319 -333,410
2008-11 1,441,048 609,506 50,453 698,786 -89,280
2008-12 1,663,861 821,227 53,815 653,565 167,661
2009-1 1,700,775 858,418 60,173 563,496 294,922
2009-2 1,554,130 700,968 57,459 582,497 118,470
2009-3 1,639,588 779,954 55,315 612,111 167,843
2009-4 1,749,802 881,555 57,175 558,194 323,361
2009-5 1,770,208 901,293 57,192 525,448 375,845
2009-6 1,680,630 809,019 57,641 438,722 370,297
2009-7 1,666,249 795,568 62,560 366,961 428,607
2009-8 1,705,407 829,366 63,515 331,450 497,916
2009-9 1,801,506 922,758 62,681 306,827 615,931
2009-10 1,936,564 1,056,405 61,673 265,058 791,347
2009-11 2,018,813 1,140,488 63,200 217,307 923,181
2009-12 2,017.698 1,138,633 63,187 169,927 968,706
2011-6 2,647,237 1,666,386 77,576 13,243 1,653,143

Is the Banking Sector Improving? Yes (lower
borrowing of reserves)
30
The federal funds rate and interest paid on
excess reserves
31
The Feds Balance Sheet

• The Fed receives interest on its assets (U.S.
  government securities loans to banks).
• The Fed pays no interest on its liabilities
  (currency and fed funds).
• The Fed is highly profitable, which fosters its
  independence. The Fed returns its profits to the
  Treasury.
• Hence the interest that the Treasury pays on
  securities held by the Fed is not a cost for the
  Government that portion of public debt is
  effectively monetized (pays 0 interest)

32

• The Quantity Theory Money and Inflation

33
The Quantity Theory of Money Quantity Equation

• MV PY
• M money supply, P the GDP deflator, Y real
  GDP
• V velocity PY/M. We define V in this way
• If V is constant and Y is beyond the Central
  Banks LR control then ...
• When the Central Bank doubles M, the result is a
  doubling of P
• Inflation is always and everywhere a monetary
  phenomenon
• This Friedman quote is not literally correct
  because of Y and V movements. But a LR
  correlation of .95 means its close enough.

34
The Evolution of Velocity (M1)

35
The Evolution of Velocity (M2)

36
Notes on the Quantity Equation

• V is defined so that the Quantity Equation holds.
  Identity P MV / Y .
• Inflation (rising P) is caused by too much money
  chasing too few goods, i.e. by M rising relative
  to Y (controlling for how much M we need to
  transact PY, which is V).
• Note inflation could rise despite fixed M because
  of falling Y or rising V. Across countries,
  however, most differences in inflation (P growth)
  are associated with differences in M growth
  correlation between M growth and inflation is
  above .95.
• V is not fixed in reality. V rises with
  financial innovation and with i (the nominal
  interest rate). Recall that i r p. If, like
  Y, r is beyond the Central Banks LR control,
  then higher inflation translates one-for-one into
  higher i. Implication V rises with the rate of
  inflation.
• Thus taking into account that V is not fixed only
  makes the channel from M growth to P growth
  stronger when M growth is high it generates
  inflation , which raises V, which in turn raises
  inflation further. This is a big deal in
  hyperinflations.

37
Money Growth and Inflation 1990
38
Money Growth and Inflation 1996-2004
Turkey
Ecuador
Indonesia
Belarus
Argentina
U.S.
Switzerland
Singapore
Correlation between inflation and money growth
0.90 over long periods of time. Data from Greg
Mankiws Text Book
39
U.S. inflation and money growth, 1960-2006
slide 39
40
Nominal Interest Rates and p
41
Monetizing Government Debt
The Central Bank buys public debt with reserves
(increases monetary base!).

• When public debt is growing faster than GDP,
  there is political pressure on the Central Bank
  to monetize some of the government debt b/c
• public debt pays interest, reserves do not
• fixed nominal debt is easier to pay off the
  higher is P.
• Large budget deficits are the underlying cause of
  hyperinflations. The debt and deficit limits in
  Europes EMU are meant to prevent member
  countries from pushing for higher inflation.
• Central Bank independence from fiscal authorities
  can insulate it from pressure to monetize the
  public debt.

42
CB Independence Inflation
43
CB Independence Inflation (Same
PictureDifferent Authors)
Data Alesina and Summers 1993 (Data from
1955-1988)
44
Hyperinflations are ...

• sometimes defined as 30 or more inflation in a
  year
• usually characterized by accelerating inflation
  (wage indexation)
• caused by rapid M growth (the Central Bank
  creating new reserves at a rapid rate)
• exacerbated by rising velocity (efforts to
  economize on M)
• highly disruptive to Y
• 1985 Bolivia 10,000, 1989 Argentina 3100, 1990
  Peru 7500, 1993 Brazil 2100, 1993 Ukraine 5000.

45
Why Do Governments Grow the Money Supply?

• Short Term Political Gains - reduce unemployment
  (or raise output). If the economy is capacity
  constrained - prices must rise (however, this
  usually occurs with a lag!)
• Accommodating Supply Shocks - The U.S. in the
  70s! (as opposed to breaking the inflation
  cycle).
• Financing Government Deficits by Printing
  Money!!!
• We will deal with these reasons more as the
  course progresses.

46
Resources

• The Fed and District Banks (see the Board of
  Governors website for FOMC minutes and speeches
  and testimony of FOMC members)
  http//www.ny.frb.org/links.html
• Foreign Central Banks http//www.bog.frb.fed.us/
  centralbanks.htm
• Fed Points (each explains something, e.g. how
  currency gets into circulation)
  http//www.ny.frb.org/pihome/fedpoint/
• Details on how open market operations work
  http//www.ny.frb.org/pihome/addpub/omo.html
• Overview of the Fed http//www.federalreserve.gov

47

• The Money Market
• Money Demand, Money Supply, and the LM Curve

48
Money Supply (Summary)

• Remember MS (cu 1)/(cu m) BASE
• Define Nominal Money Supply (Ms)
• Fed conducts monetary policy to increase Money
  Supply
• - Open Market Purchases (increase Base)
• - Decrease the reserve ratio (decrease m)
• - Decrease the Discount Rate (decrease m)
• Also influenced by the public
• - Bank runs (increase in cu)
• - Bank precautionary motives (increase in m
  above m)

49
Money Demand

• Agents decide how much wealth to keep as money
  Portfolio allocation decision
• 3 main characteristics of assets matter
• Expected Return The higher the expected return
  the higher consumption the
  agent can enjoy!
• Risk Agents are risk-averse, hence to hold a
  risky asset, it must have a higher expected
  return
• Liquidity The easier is to exchange the asset
  for goods, services or other assets, the
  more attractive is the asset.
• Money is highly liquid!
• Money is the most liquid BUT has a low return!

50
Money Demand (continued)

• Nominal money demand is proportional to the
  price level. For example, if prices go up by 10
  then individuals need 10 more money for
  transactions.
• As Y increases, desired consumption increases
  and so individuals need more money for the
  increased number of desired transactions. This is
  the liquidity demand for money.
• As the nominal interest rate on non-money
  assets (bonds), i, increases the opportunity cost
  of holding money increases and so the demand for
  nominal money balances decreases.
• Since i r pe, we can decompose the effects
  on an increase in i into real interest rate
  increases (holding expected inflation fixed) and
  expected inflation increases (holding the real
  interest rate fixed).

51
Money Demand (continued)

• Other factors affecting Money Demand
• Wealth
• Risk
• Liquidity of Alternative Assets
• Payment Technologies

52
Money Demand Function

• Our model for the demand for nominal money
  balances takes the following form
• Md
  PLd(Y, i)
• where
• Md demand for nominal money balances
  (demand for M1)
• Ld demand for liquidity function
• P aggregate price level (CPI or GDP
  deflator)
• Y real income (real GDP)
• i nominal interest rate on non-money
  assets

53
Real Money Balances

• The demand for real balances
• Since the demand for nominal balances is
  proportional to the aggregate price level, we can
  divide both sides of the nominal money demand
  equation by P.
• This gives the liquidity demand function or the
  demand for real balances function
• Md/P
  Ld(Y, r pe)
• The left-hand-side of the above equation is the
  demand for nominal balances divided by the
  aggregate price level or the demand for real
  balances (the real purchasing power of money).
• The right-hand side is the liquidity demand
  function. The demand for real balances is
  decomposed into a transactions demand for money
  (captured by Y) and a portfolio demand for money
  (captured by r and pe).

54
Money Demand

55
Money Market

• The Money Market is in Equilibrium when
• Real Money Demand Real Money Supply
• where Real Money Supply Ms/P
• Real Money Demand Md/P Ld(Y, r pe)
• Note The money supply curve does not change
  with interest rates (it is verticle)
• What shifts real money supply M, P
• What shifts real money demand Y, pe

56
Money Market Equilibrium
Money Market
Ms

re
Md Ld(Y,pe)
M/P
57
Money Market Equilibrium Increasing Y

Money Market
Ms
r0
Md Ld(Y0,..)
M/P Suppose Y increases from Y0
to Y1 (Holding Money Supply fixed!)
58
Money Market Equilibrium Increasing Y

Money Market
Ms

r1
r0
Y increases
Md Ld(Y1,)
Md Ld(Y0,..)
M/P Suppose Y increases from Y0
to Y1 (Holding Money Supply fixed!)
59
Positive Relationship Between Y and r (in Money
Market)

r1
r0
Y Y1 Y
60
Positive Relationship Between Y and r (in Money
Market)

We will refer to this as the LM curve

r1
r0
Y Y1 Y
61
The LM (Liquidity-Money) Curve

• LM Curve (drawn in (Y-r) space) - represents
  the relationship of Y and r through the money
  market (specifically - Ys affect on money
  demand). Reference Supplemental Notes 10
• The LM Curve relates real interest rates to real
  changes in output in the money market.
• As Y increases - Md shifts upwards - causing real
  interest rates to rise (increase in transactions
  demand increases the demand for money).
• What shifts the LM curve?
• Money Increasing Money Supply increases M/P
  causing the LM curve to the right.
• Prices Increasing Prices causes real Money
  Balances to fall shifting LM curve to the
  left.
• p e Increasing expected inflation causes
  returns on bonds (assets other than money) to
  increase making it less attractive to hold cash.
  Causes LM curve to shift right!

62
Shifting the LM curve An Increase in M

• Thought experiment Suppose M increases. What
  level of Y is needed to hold r constant.
• Or, put another way, what would happen to r if Y
  was held constant?

Ms Ms1
LM(M0)

LM(M1)
r0
x
r0
x
z
r1
r1
z
Md(Y0)
Y0
Money Market
LM curve
An increase in the nominal money supply will
cause the LM curve to shift to the right (or
shift down, if you prefer that metric).
63
Interest Rates and Output

• There are two effects driving the relationship
  between interest rates and output
• 1) The IS curve. As interest rates fall,
  Investment increases and Y increases.
• r falling causes Y to increase (negative
  relationship - the IS curve)
• 2) The transaction motive for holding money. As
  Y increases, demand for money increases and r
  increases.
• Y increasing causes r to increase (positive
  relationship - the LM curve)
• In equilibrium, both relationships need to be
  satisfied. We will work through this intuition
  in the next topic.
• However, before we do, we will see why we need to
  summarize the money market as the LM curve (as
  opposed to just Money Supply and Money Demand).
• Remember Everywhere along the LM curve
  represents equilibrium in the money market.

64
An Illustration of Monetary Feedback in Money
Market
Suppose M increases
Money Market
Ms Ms1

0
re
1
re1
Md Ld(Y,pe)
M/P M1/P
65
An Illustration of Monetary Feedback in Money
Market

• A fall in r, will increase I, causing Y to
  increase - which causes Md (and r) to increase.

Money Market
Ms Ms1

Y increases
0
re
2
re2
1
re1
Md1 Ld(Y1,pe)
Md Ld(Y,pe)
M increases
M/P M1/P

• This process is known as monetary feedback -
  increasing M will cause r to fall, I to
  increases, Y to increase, money demand to
  increase and r to increase. The net effect on r
  will be to fall.
• The IS-LM representation will express this
  process in a more concise form?