Money, Interest, and Inflation Chapter 27

Quantity of Money Demanded The amount of money that households and firms choose to hold What determines QMD? Price of Money (can be thought of in two ways) The Value of Money Opportunity Cost of Money Households must compare the benefit from holding money to its OC

OC of Holding Money Forgone interest or the goods/services that could have been purchased with that interest If an investment pays back 10% in dividends every year, what is the opportunity cost of holding $100 instead of investing the $100? $100(.10) = $10 OC = anything you could have purchased with that $10

OC = Nominal Interest Rate Nominal Interest Rate = Real Interest Rate + Inflation Rate The higher the nominal interest rate, the smaller is the quantity of money demanded

Demand for Money (MD) The relationship between the quantity of money demanded and the nominal interest rate Nominal Interest Rate MD Quantity of Money

Changes in the Nominal Interest Rate When the nominal interest rate increases, the opportunity cost of holding money increases, which causes the quantity of money demanded to decrease. Nominal Interest Rate B inB A inA MD QB QA Quantity of Money

Demand for Money Influences Price Level (PL) When PL increases by x%, MD increases by x%. Real GDP When real GDP increases, MD increases. Financial Technology Credit cards decrease MD since it increases the OC of holding money

Sketch the Effects #1 When price levels fall, the demand for money shifts which direction?

Sketch the Effects #2 When real GDP increases, the demand for money shifts which direction?

Supply of Money (MS) The relationship between the quantity of money supplied and the nominal interest rate Determined by the actions of the banking system and the Fed On any given day, the quantity of money is fixed. MS Nominal Interest Rate Quantity of Money

Money Market Equilibrium MS Nominal Interest Rate in MD QM Quantity of Money

Bond Prices An investment that promises to pay periodic interest payments along with the face value on the maturity date. Ex. $1,000 bond with a 20% interest rate paid quarterly for 2 years Each quarter you will receive 5% interest or $50 (1,000 x .05) You purchase the bond for $1,000, and by the end of the 2 years, you receive 1,000 + 50(8) = $1,400.

How Changing Interest Rates Affect Bond Prices Ex. $1,000 bond with a 20% interest rate paid quarterly for 2 years Assume interest rates decrease to 15%. How does this impact the price of this bond?

Interest rates and bond prices move in opposite directions

When interest rates are above market equilibrium There is an excess supply of money Price of bonds decrease People buy bonds, which lowers the interest rate to market equilibrium MS Nominal Interest Rate i1 in MD QMD QMS Quantity of Money

When interest rates are below market equilibrium There is an excess demand for money Price of bonds increases People sell bonds, which raises the interest rate to market equilibrium MS Nominal Interest Rate in i1 MD QMS QMD Quantity of Money

Lowering the Interest Rate Monetary Action: Fed increases the MS MS2 MS Nominal Interest Rate in i2 MD QM QM2 Quantity of Money

Raising the Interest Rate Monetary Action: Fed decreases the MS MS2 MS Nominal Interest Rate i2 in MD QM2 QM Quantity of Money

Review How does the Fed control the money supply? A: purchasing and selling bonds

Open Market Operations If the Federal Reserve wants to lower interest rates, what open market operation will it institute? If the Federal Reserve wants to raise interest rates, what open market operation will it institute?

Sketch the Effects #3 Sketch a money market graph Illustrate the net effect of the Fed purchasing government securities in the open market.

Sketch the Effects #4 Sketch a money market graph Illustrate the net effect of the Fed selling government securities in the open market.

Money, the Price Level, and Inflation Chapter 27.2

The Long Run The economy at full employment when real GDP equals potential GDP

The Value of Money The quantity of goods and services that a unit of money will buy Value of Money = 1/PL = 1/(GDP Price Index/100) = 100/GDP Price Index As the price level rises, the value of money falls

Value of Money Example The nominal price of a t-shirt is $20. The GDP deflator is 125. What is the real price of a t-shirt? You have $100 in your wallet. Price levels rise by 10%. How much is that $100 really worth? You have $500 in your wallet. Price levels fall by 25%. How much is that $500 really worth? 20/1.2 = 200/12 = 100/6 = 50/3 = $16.67

Long Run Demand for Money (LRMD) MS Value of Money 1/PL LRMD QM Quantity of Money

As the value of money falls, price levels rise, causing inflation

The LR Effect of a Change in the Quantity of Money Fed increases the money supply Nominal interest rates fall People want to borrow and spend more money Because real GDP = potential GDP, production is constant and people can’t buy more This causes price levels to rise The value of money decreases A new long-run equilibrium is established with a price level increase that’s proportional to the increase in the money supply

When MS increases, what happens to the PL? What does this result in? Value of Money 1/PL1 1/PL2 LRMD QM Quantity of Money

The Babysitting Coop Listen to the Planet Money podcast “Trouble Inside a Babysitting Economy” Start: 0:00 End: 8:50 Reflection Questions: What created the shortage of “money?” What did the coop organizers do to promote people to spend their babysitting tokens? What happened to the value of the currency?

The Velocity of Circulation The average number of times in a year that each dollar of money gets used to buy final goods and services.

Example of the Velocity of Circulation GDP Price Index = 125 Real GDP = ϒ = $8 trillion M = $2 trillion V = (1.25 * 8) / 2 = 1.25 * 4 = 5 V = 5 means that each dollar in circulation, on average, gets used about 5 times ϒ = upsilon

Velocity of Circulation for M1 in US *Graph downloaded from Federal Reserve Economic Data (FRED) website What does the velocity of circulation reveal about the state of the economy?

Equation of Exchange Equation of Exchange: an equation that states that the quantity of money multiplied by the velocity of circulation equals the price level multiplied by real GDP MV = Pϒ M = quantity of money supplied V = velocity of circulation P = price level ϒ = real GDP

The Quantity Theory of Money The proposition that when real GDP equals potential GDP and the velocity of circulation is constant, an increase in the quantity of money brings an EQUAL percentage increase in the price level. MV = Pϒ

Why do we care about V? Knowing V allows us to determine how many goods and services were purchased Example: V = 5, QM = $2 trillion $10 trillion of goods and services were purchased

Federal Reserve Economic Data (FRED) Run by the Fed of St. Louis

QM and Inflation When QM growth rate increases, inflation rate increases When QM growth rate decreases, inflation rate decreases

Hyperinflation When the inflation rate exceeds 50% a month (12,875% per year) Occurs when the quantity of money grows at a rapid pace Often a result of government expenditures being much greater than tax revenue, causing the government to print more money Causes the population to minimize their holdings of local money Ex. Zimbabwe in 2008, inflation rate = 231,150,888.87% per year

Instances of Hyperinflation Take a look at the 55 instances of hyperinflation throughout the world. If a Big Mac costs $3.99 today, how much would it cost at the end of a year if the US was currently experiencing hyperinflation at the same rate as… Hungary in 1945 (Table 1) Brazil in 1989 (Table 2) Zimbabwe in 2007 (Table 3)

How Four Drinking Buddies Saved Brazil

Sample AP Problem The required reserve ratio is 0.2 and the Federal Reserve sells $1 million in securities. If there are no leakages and banks do not hold excess reserves, then what is the change in the money supply? A decrease of $5 million

Sample AP Problem The Federal Reserve can cause an increase in interest rates in an attempt to… Reduce inflation Reduce cyclical unemployment Reduce structural unemployment Increase aggregate demand Increase investment spending Support your answer with a graph. A

Sample AP Problem If the velocity of money is stable, the quantity theory of money predicts that an increase in the money supply will lead to a proportional… Increase in the nominal output Decrease in the price level Decrease in the nominal interest rate Decrease in the real interest rate Decrease in the unemployment rate A

Sample AP Problem Which of the following is most likely to occur when the Federal Reserve buys government bonds on the open market? The demand for money will decrease The government’s debt will decrease Interest rates will decrease The discount rate will increase Investment demand will decrease C

Sample AP Problem Which of the following actions by the Federal Reserve reduces the ability of the banking system to create money? Decreasing the federal funds rate Decreasing the discount rate Increasing the money supply Increasing the reserve requirement Buying government bonds on the open market D

Sample AP Problem Which of the following government policies can reduce the rate of inflation in the short run? Providing investment tax credits for businesses Reducing personal income tax rates Selling bonds on the open market Decreasing the reserve requirement Decreasing the discount rate C

Sample AP Problem Which of the following is true of the quantity of money demanded? It rises when interest rates rise, because the return from holding money increasing It falls when interest rates rise, because the opportunity cost of holding money increases It remains constant when interest rates rise, as long as inflation remains constant It rises when interest rates rise, as long as inflation is declining It falls when the money supply increases, as long as inflation remains constant B

Sample AP Problem Expansionary monetary policy can affect the economy through which of the following chains of events? Increasing he discount rate lowers the real interest rate, which raises investment Reducing taxes lowers the discount rate, which raises consumption Increasing government expenditure lowers the interest rate, which raises investment Increasing the reserve requirement decreases the interest rate, which increases investment Buying bonds increases the money supply, which lowers the interest rate E

Sample AP Problem – Money Markets A drop in credit card fees causes people to use credit cards more often for transactions and demand less money. Using a correctly labeled graph of the money market, show how the nominal interest rate will be affected. Given the interest rate change in part (a), what will happen to bond prices in the short run? Given the interest rate change in part (a), what will happen to the price level in the short run? Explain. Identify an open-market operation the Federal Reserve could use to keep the nominal interest rate constant at the level that existed before the drop in credit card fees. Explain.

Sample AP Problem – Money Market and Loanable Funds Market Interest rates are important in explaining economic activity. Using a correctly labeled graph of the money market, show how an increase in the income level will affect the nominal interest rate in the short run. Using a correctly labeled graph of the loanable funds market, show how a decision by households to increase saving for retirement will affect the real market interest rate in the short run. Suppose that the nominal interest rate has been 6 percent with no expected inflation. If inflation is now expected to be 2 percent, determine the value of each of the following. The new nominal interest rate The new real interest rate