Jennifer P. Wissink ©2018 Jennifer P. Wissink, all rights reserved. Fiscal & Monetary Policy with a Goods & Services Market & Money Market Lecture 18 Jennifer P. Wissink ©2018 Jennifer P. Wissink, all rights reserved. October 25, 2018 1 1

Liabilities + Net Worth Liabilities + Net Worth Assets Assets The Fed HSBC Liabilities + Net Worth Liabilities + Net Worth Assets Assets Government Securities HSBC’s Reserves Reserves at The Fed DD-public Currency in Circulation Net Worth Property Loans Paintings Net Worth Adam Liabilities + Net Worth Assets DD Loan Currency Car Net Worth Government Securities

Households and the Transaction Motive for Money Demand There is a trade-off between the liquidity of money and the interest income offered by other kinds of assets. The transaction motive is the main reason that people hold money—to buy things. inventory analysis synchronization problems Lots of interesting work on this. Pioneered by William Baumol and James Tobin. Note that firms also have a transaction motive for holding money. Get a money demand function: MD = f(interest rate(r), income(Y), price level(PL), other stuff(OS)) if r  MD and if r  MD  if Y  MD  and if Y  MD  if PL  MD  and if PL  MD 

Speculators and the Speculative Motive for Money Demand Very Important: Recall there is an inverse relationship between the market value of bonds ($PB) and the market interest rate (r). So... when interest rates are high, speculators may wish to hold bonds (rather than money), with the hope of selling their bonds when the interest rate falls & bond prices rise. “What goes up, must come down” So quantity of money demanded by speculators at high interest rates is low. Likewise... when interest rates are low, speculators may wish to hold money (rather than bonds), with the hope of buying bonds when the interest rate rises & bond prices fall. “What goes down, must come up” So quantity of money demanded by speculators at low interest rates is high. So… supports the idea that there is a negative relationship between the interest rate, r, and the quantity of money demanded.

The Money Demand Curve Hold Y & PL constant at some “exogenous” level and vary r. Changing r  movement along money demand curve. Changing Y and/or PL  shift in money demand curve.

The Equilibrium Interest Rate

When r > r* At r1, the amount of money in circulation is higher than households and firms wish to hold. They will attempt to reduce their money holdings by buying bonds. $Pbonds  r

When r < r* At r2, households & firms don’t have enough money to facilitate ordinary transactions. They will attempt to hold more money and will shift assets out of bonds and into money by selling their bonds. $Pbonds  r

How a Change in the Money Supply Impacts the Interest Rate An increase in the money supply, MS↑, will... ...shift the money supply curve to the right, which… ...creates excess supply of money… … which puts pressure on $Pbonds to rise  r Do the opposite story for yourself.

How a Change in Y Impacts the Interest Rate An increase in aggregate output (income), Y↑, will... ...shift the money demand curve to the right, which… ...creates excess demand for money… … which puts pressure on $Pbonds to fall  r↑

How a Change in the PL Impacts the Interest Rate An increase in the price level, PL↑, will... ...shift the money demand curve to the right, which… ...creates excess demand for money… … which puts pressure on $Pbonds to fall  r↑

Putting It Together: The Goods & Services Market & The Money Market From the Money Market we get r* where MD(r*, Y, PL) = MS From the G&S Market we get: AEd = C(Yd) + Id(r*) + G + EX – IM In equilibrium we solve for Y* where Y* = AEd(Y*) Two new reality wrinkles: Id(r) depends negatively on the equilibrium interest rate r Why? Projects have lower present value and look less attractive MD (r, Y, PL)depends positively on Y&PL and depends negatively on r Now we have ties (r, Y and PL) that bind the Money Market to the Goods & Services Market! There is an equilibrium value for Y* & the interest rate, r*, that is consistent with the existence of equilibrium in both the Goods & Services Market and the Money Market, simultaneously.

Putting It All Together Money Market Desired Investment 45° help G&S Market aka Keynesian Cross

Policy (Monetary and Fiscal) with the G&S Market & the Money Market Suppose Y* < YFE Recessionary gap Expansionary policy considered Can be monetary and/or fiscal Suppose Y* > YFE  Inflationary gap Contractionary policy considered

Expansionary Monetary Policy via an Increase in MS Id M AEd 45° help Ms r Id AEd Y MD r Id AEd Y Finally: get a new lower r* and higher Y* Note: with feedback effect, there is a smaller final change in r* and Y* So, efficacy of monetary policy depends on some important sensitivities! Y

Expansionary Fiscal Policy via an Increase in G AEd G AEd Y MD r Id AEd Y 45° help Finally… get a new higher r* and higher Y* Note: with feedback effect, there is a smaller final change in Y* Y r r Id M 18

New Issue: The Crowding-Out Effect of Expansionary Fiscal Policy The crowding-out effect is the tendency for increases in government spending to cause reductions in private investment spending. The crowding-out effect depends on the sensitivity or insensitivity of planned investment spending to changes in the interest rate and the sensitivity or insensitivity of money demand to changes in Y and the interest rate. So, efficacy of fiscal policy depends on some important sensitivities! 19

i>clicker question Suppose the fiscal guys decide to stimulate the economy by increasing $G. Suppose the monetary guys want to help out in any way they can to make the fiscal guys look good. So, they would... sit on their hands and do nothing. buy government securities from the public. sell government securities to the public. decrease taxes. increase the discount rate.

Issue: Fed Accommodation of Fiscal Policy (of an Expansionary Fiscal Policy, in this case) An expansionary fiscal policy (higher government spending or lower taxes) will increase aggregate output (income). In turn, higher income will shift the money demand curve to the right, and put upward pressure on the interest rate. If the money supply were unchanged following an increase in the demand for money, the interest rate would rise. But if The Fed were to “accommodate” the fiscal expansion, the interest rate would not rise. What would be true if The Fed accommodated a fiscal contraction? 21