1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 28 Money, Interest Rates, and Economic Activity

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-2 In this chapter you will learn to 1. Explain why the price of a bond is inversely related to the market interest rate. 2. Describe how the demand for money is related to the interest rate, the price level, and real GDP. 3. Explain how monetary equilibrium determines the interest rate in the short run. 4. Describe the transmission mechanism of monetary policy. 5. Describe the difference between the short-run and long-run effects of monetary policy. 6. Describe the condition under which monetary policy has the largest short-run impact on real GDP.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-3 Present Value and the Interest Rate Present value: - the value now of one or more payments or receipts made in the future Consider an asset that pays $X in one year’s time. If the interest rate is i% per year, the PV of the asset is PV = $X/(1+i) Notice that, ceteris paribus, the PV is negatively related to the interest rate. Understanding Bonds

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-4 Suppose a $1000 bond pays 10% at the end of each of three years, at which point it is redeemed. What is the PV if the interest rate is 7 percent? PV = $100 + $100 + $1100 1.07 (1.07) 2 (1.07) 3 More generally, PV = R 1 + R 2 + … + R T (1+i) (1+i) 2 (1+i) T A Sequence of Future Payments

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-5 Present Value and Market Price - buyers should be prepared to pay no more than the bond’s PV - sellers should be prepared to accept no less than the bond’s PV  the equilibrium market price of a bond (or other financial asset) should be the PV of the stream of income generated by the bond. Consider a competitive market for bonds:

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-6 Interest Rates, Market Prices and Bond Yields This discussion leads to two important propositions: 1. The PV of a bond is negatively related to the market interest rate. 2. The market price for a bond should equal its PV. Since a bond’s yield is inversely related to its price, we conclude that: - Market interest rates and bond yields tend to move together.

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-7 Bond Riskiness An increase in the riskiness of any bond leads to a decline in its expected PV, and thus to a decline in the bond’s price.  high risk leads to high yield

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-8 The Demand for Money The amount of money that everyone wishes to hold is the demand for money. The opportunity cost of holding money is the interest that could have been earned if the money had been used to purchase bonds. Reasons for Holding Money

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-9 the transactions motive the precautionary motive the speculative motive There are three reasons for holding money: The Determinants of Money Demand We focus on three variables: real GDP (+) the price level (+) the interest rate (-) The Demand for Money

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-10 Figure 28.1 Money Demand as a Function of the Interest Rate, Real GDP, and the Price Level The M D curve is sometimes called the liquidity preference function. Changes in the interest rate cause movements along the M D curve. Changes in Y or P cause the M D curve to shift.

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-11 Real GDP An increase in real GDP increases the volume of transactions in the economy  increase in desired money holding The Price Level An increase in the price level leads to an increase in the dollar value of transactions even if there is no change in the real value of transactions. In order to carry out the same real value of transactions, as P rises:  desired money holding increases The Money Demand Curve

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-12 Money Demand: Summing Up – + + M D = M D (i, Y, P) Remember there are two assets — bonds and money. The decision to hold money is the same as the decision not to hold bonds.

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-13 Figure 28.2 Monetary Equilibrium Monetary equilibrium occurs when the quantity of money demanded equals the quantity of money supplied:  equilibrium interest rate

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-14 Monetary transmission mechanism: - connects changes in M D and/or M S with aggregate demand Three stages: 1. ΔM D or ΔM S  Δ in equilibrium interest rate 2. Δi  Δ in desired investment expenditure 3. ΔI D  Δ in AD The Monetary Transmission Mechanism

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-15 Figure 28.3 Changes in the Equilibrium Interest Rate

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-16 Figure 28.4 The Effects of Changes in the Money Supply on Desired Investment Expenditure

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-17 Figure 28.5 The Effects of Changes in the Money Supply on Aggregate Demand Changes in desired investment lead to a shift in the AE function, and thus a shift in the AD curve.

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-18 Figure 28.6 Summary of the Monetary Transmission Mechanism

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-19 In an open economy with mobile financial capital, there is an extra channel to the transmission mechanism. As interest rates change, financial capital flows between countries, putting pressure on the exchange rate. As the exchange rate changes, net exports change, adding to the effect on aggregate demand. An Open-Economy Modification

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-20 Figure 28.7 The Open-Economy Monetary Transmission Mechanism

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-21 The Slope of the AD Curve In Chapter 23, there were two reasons for the negative slope of the AD curve: - ΔP leads to Δwealth - ΔP leads to ΔNX We can now add a third reason — the effect of interest rates. A rise in P leads to: - an increase in money demand - a higher interest rate  reduces desired investment

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-22 The Strength of Monetary Forces 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 Y*. Money neutrality is the idea that changes in the money supply do not have real effects on the economy.

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-23 Figure 28.8 The Long-Run Neutrality of Money What does money neutrality look like? -M D shifts up as P and Y adjust to new long-run equilibrium - interest rate returns to its initial level

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-24 Figure 28.9 Inflation and Money Growth across Many Countries

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-25 The short-run effect of a change in the money supply depends on the extent of the shift of the AD curve. Short-Run Non-Neutrality of Money Important debate in the 1950s and 1960s regarding the effectiveness of monetary policy: - centered around the slopes of the M D and I D curves - Keynesians versus Monetarists

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-26 Figure 28.10 Two Views on the Strength of Monetary Changes

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-27 Monetarists argued that monetary policy was very effective: - M D curve was relatively steep - I D curve was relatively flat Keynesians argued that monetary policy was not very effective: - M D curve was relatively flat - I D curve was relatively steep Keynesians versus Monetarists

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-28 Today, much empirical support that the money demand curve is quite steep:  changes in money supply do lead to changes in the equilibrium interest rate  monetary policy can be effective There is much less compelling evidence regarding the slope of the investment demand curve. Empirical Evidence