1 Money, Interest, Real GDP and the Price Level Lecture notes 6 Instructor: MELTEM INCE.

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Presentation transcript:

1 Money, Interest, Real GDP and the Price Level Lecture notes 6 Instructor: MELTEM INCE

2 The Demand for Money Curve The demand for money is the relationship between the quantity of real money demanded and the interest rate, all other things remaining the same. When the interest rate changes there is a movement along the demand for money curve.

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4 Interest Rate Determination The interest rate is the amount received by a lender and paid by a borrower expressed as a percentage of the amount of the loan.

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6 Interest Rate Determination This formula means that the higher the price of the bond, other things remaining the same, the lower is the interest rate.

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8 Nominal and Real Interest The nominal interest rate is the percentage return on an asset such as a bond expressed in terms of money. The real interest rate is the percentage return on an asset expressed in terms of what money will buy. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The nominal interest rate is the opportunity cost of holding money. The real interest rate is the opportunity cost of spending.

9 Short-Run Effects of Money on Real GDP, and the Price Level  Investment and consumption expenditures decrease.  The dollar rises and next exports decrease.  A multiplier process unfolds.

10 Short-Run Effects of Money on Real GDP, and the Price Level

11 Short-Run Effects of Money on Real GDP, and the Price Level

12 Long-Run Effects of Money on Real GDP and the Price Level  An increase in the quantity of money at full employment increases real GDP and raises the price level.  The money wage rate rises, which decreases short- run aggregate supply and decreases real GDP but raises the price level.  In the long run, an increase in the quantity of money leaves real GDP unchanged but raises the price level.

13 Long-Run Effects of Money on Real GDP and the Price Level  Figure 1 illustrates the effects of an increase in the quantity of money starting from potential GDP.  In part (a), the Fed increases the quantity of money and lowers the interest rate.

14 Long-Run Effects of Money on Real GDP and the Price Level  In part (b), aggregate demand increases  Real GDP increases to $10.2 trillion and the price level rises to 105.

15 Long-Run Effects of Money on Real GDP and the Price Level With an Inflationary gap, the money wage rate rises and short Run aggregate Supply decreases.

16 Long-Run Effects of Money on Real GDP and the Price Level  Back in the money market, the rise in the price level decreases the quantity of real money.  The interest rate rises to 6 percent.