Money and Interest Rates

1. Money and Interest Rates Choosing between consumption and savings

2. The Market Interest Rate • What determines the equilibrium interest rate in financial markets? • A financial market is any market in which borrowers and lenders interact • The supply of funds being forwarded by lenders and the demand for funds by borrowers determines both the quantity of lending/borrowing and the interest rate at which these loans are made. • One way to analyze this market would be to directly examine the supply and demand for bonds (loans). • An alternative method would be to examine the supply and demand for money

3. The Liquidity Preference Framework • There are essentially two things you can do with your wealth: • Spend it using money • Save it by purchasing bonds • Breaking down wealth into these two broad asset categories yields the following identity: • BS + MS = BD + MD • Equilibrium in the bond market will be achieved when BS = BD. • The interest rate will adjust until the quantity of bonds supplied is equal to the quantity of bonds demanded. • At the equilibrium interest rate, BS = BD • Rearranging the identity above: BS – BD = MD – MS • At equilibrium, BS – BD = 0, so… • MS = MD • When the bond market is in equilibrium, the supply of money is equal to the demand for money • We can find the equilibrium interest rate by looking only at the money market!

4. The Demand for Money and Interest Rates • We assume that if you hold your wealth as money, you earn no interest, while you do earn interest if you hold your wealth as bonds. • How does your demand for money change when the interest rate rises? • The opportunity cost of each dollar held as money is the foregone interest that could have been earned had you held that dollar in bonds • As the interest rate rises, so too does the opportunity cost of money • The quantity of money demanded is inversely related to the interest rate on bonds.

5. The Supply of Money and Interest Rates • The current monetary system in just about every country has a single central bank responsible for issuing currency • In the U.S., the only entity that can issue dollars is the Federal Reserve. • In other words, private banks cannot issue their own currency • Because the supply of money is controlled by the central bank and no one else, we assume that the money supply is invariant to the interest rate • In other words, the supply of money will stay the same regardless of whether the interest rate is 1%, 5% or even 1000%. • This is operationalized by drawing the money supply curve as a vertical line at the current money supply.

6. The Money Market Nominal Interest Rate (i) MS 7% 5% 3% MD 400 1000 Quantity of Money ($ billions) 700 Money Shortage Money Surplus

7. Changes in Equilibrium Interest Rates • One of the most useful features of the liquidity preference framework is that it allows us to see how changes in the demand and supply of money affect interest rates. • Equilibrium interest rates will increase if there is a… • Increase in money demand (+) • Decrease in money supply (+) • Equilibrium interest rates will decrease if there is a… • Decrease in money demand (-) • Increase in money supply (-)

8. Shifts in Money Demand • In Keynes original analysis, two things would cause the demand for money to change: • An Increase in Income/Wealth • With more income, people would like to consume more. To increase consumption, you need more money. • Money demand shifts right, causing interest rates to rise • An Increase in Prices • With higher prices, the same quantity of money held buys fewer goods and services. To maintain consumption, people need to hold more money. • We can also consider several other factors that increase money demand: • An increase in the risk of non-monetary assets (i.e. bonds) • A decrease in the liquidity of non-monetary assets • An increase in the nominal interest rate on money

9. Interest Rates Rise when Income Rises Nominal Interest Rate (i) MS 7% 5% MD2 MD1 900 Quantity of Money ($ billions) 700

10. Interest Rates Fall when Bonds become less Risky Nominal Interest Rate (i) MS 5% 3% MD1 MD2 Quantity of Money ($ billions) 400 700

11. Shifts in Money Supply • Since the central bank is the sole issuer of money, any changes in the money supply must come directly from central bank policy (monetary policy) • At its most basic level, an increase in the money supply is just the central bank printing up more money • Operationally, the central bank changes the money supply through three channels (much more on this later) • Buying and selling bonds from the public in exchange for money • Changing banks reserve requirement • Changing the discount rate at which banks borrow from the central bank at. • Using these tools, the central bank can lower interest rates by raising the money supply and increase rates by cutting the money supply. • Note that this analysis only considers the short run and not the long term consequences of changes to the money supply.

12. Friedman’s Challenge to Liquidity Preference • Milton Friedman argued that while Keynes’ analysis was technically correct, he failed to consider the longer term effects of monetary policy. • Friedman argued that increasing the money supply may actually cause interest rates to go up! • An increase in the money supply will cause income to rise, spurring an increase in money demand and interest rates • An increase in the money supply will stimulate spending, which will then cause prices to rise. Higher prices will increase money demand and raise interest rates. • If the increase in money supply is continuous, then people will expect higher inflation. This causes the nominal interest rate to rise • Fisher effect: i = r + πe

13. Interest Rates and an Increase in the Money Supply Growth Rate • So what happens to interest rates if the central bank increases the rate at which the money supply grows? • The liquidity preference theory argues a decrease in interest rates as people will hold excess cash balances • People will try to convert their excess cash into bonds. • Doing so will increase the number of people offering loans, which must push interest rates down. • Friedman’s theory argues an increase in interest rates as the expansion in the money supply growth rate will cause income, price levels, and expected inflation to all rise.

14. Which Theory Wins?

15. The Empirical Evidence