Money Demand and Transmission

1. Money Demand and Transmission • The ‘monetary transmission mechanism’ captures the steps and pathways through which increases in the money supply impacts the economy.

2. Money Demand and Transmission During normal times changes in the money supply are mostly confined to interest rates and credit markets, with a lagged effects on output, jobs and inflation. During ‘hyperinflations’ an increasing money supply drives up prices immediately and causes economic chaos.

3. Outline • Money Demand • Two different monetary paths or disequilibrium processes • Keynesian credit market view of money • The equilibrium interest rate • OMO and the money market • Quantity Theory of Money (QTM) • hyperinflations

4. Motives for holding money • There are three motives for holding money: • Transactions motive • Speculative motive • Precautionary motive #3, #1, #2 Md=P(m0+myY+mrr )

5. Motives for holding money #3, #1, #2 Md=P(m0+myY+mrr ) • Transactions motive, ‘Y’ our income and output important • Speculative motive ‘r’ the interest rate matters • Precautionary motive mathematically this will be a constant

6. Transaction Motive • The amount of money people want to hold for transactions is proportional to their spending and income. It is some fraction of their nominal income. • Average money holdings rise if either real income or prices rise.

7. Speculative Motive • The ‘speculative’ motive for holding money comes from expected changes in bond prices. • We may hold money (rather than bonds) because we expect bond prices to fall sometime soon. We will hold money now and buy bonds only after they fall in price.

8. Present Value and Bonds • The present value of $100 next year depends on the interest rate between now and then. • PV=($100)/(1+r) where ‘r’ is the interest rate because PV*(1+r)=$100. • The Present Value of a Bond is its price, so when ‘r’ rises bond prices fall.

9. Present Value and Bond Prices • Bond prices are the present value of future payments. Long formulas are needed if there are many interest payments and a final ‘capital’ repayment. • Bond prices ALWAYS fall when interest rates rise. • PV=($100)/(1+r) • When ‘r’ rises the PV falls.

10. PV and the Speculative Motive • So when interest rates are unusually low we generally expect them to rise, and bond prices to fall. So we generally have a high ‘speculative demand’ for money. r low interest rates and a high speculative demand for money. Md M

11. 3rd Motive: Precautionary • Precautionary money demand refers to holding money for emergencies or to avoid costly fines for not promptly paying bills and obligations. • The historical lecture on the ‘natural origins’ of money showed that we have a deep attachment to money for this reason.

12. Opportunity Cost • What does it cost us to hold money? • Our wealth could have been in bonds. • In the past checking accounts paid no interest so the interest rate on bonds was the opportunity cost of money.

13. Shape of Md • Md slopes down because the opportunity cost of holding money is the interest rate. • Md shifts if income, prices or the precautionary demand changes. r Md Md

14. Shift of Md • Md shifts right if: • real income rises • prices rise • the precautionary motive increases due to fears of a credit crunch r Md Md

15. Two paths for monetary policy • 1st path, emphasized in the book: more money lowers interest rates and stimulates spending because borrowing is cheaper. (Interest rate story) • 2nd path, not emphasized in the book: more money may simply be spent. Driving up spending and prices. (QTM story.) • which happens? Just depends on whether we buy bonds (#1) or goods (#2) when we have excess money. Of course we could see a bit of both.

16. The interest rate story • At r #1 QMd< QMs • so people buy bonds with the excess money. • This does not change the amount of money, but it does raise bond prices. • Higher bond prices are equivalent to lower interest rates. • The interest rate keeps falling till we get to equilibrium. r Ms #1 Md M

17. The interest rate story • This is an exception to the general rule that the “short side” of the market determines quantity. • Here the FRB and banks determine the amount of money and money demanders can only pass it around between themselves while lowering its price. r Ms #1 Md M

18. The Equilibrium Interest Rate • At r2, households don’t have enough money to facilitate ordinary transactions. They will shift assets out of bonds and into their checking accounts.

19. Changing the MoneySupply to Affect the Interest Rate • An increase in the supply of money lowers the rate of interest.

20. FRB Monetary Policy • The FRB controls interest rates in the macroeconomy by buying and selling US gov. bonds. • This buying and selling is called ‘Open Market Operations’ as this is the open market for gov. bonds.

21. Steps in expansionary OMO • FRB in NYC buys Gov. Bonds • FRB checks are deposited with commercial banks and banking reserves rise • Commercial banks make more loans and do so by increasing the money supply in the form of checking accounts • The interest rate falls • Investment spending and Consumption spending rise • The increase in spending sets increases income and spending according to the spending multiplier • The increase in income and spending may, or may not, cause some increase in inflation later on.

22. FRB Balance Sheet, May 24 ’04In Billions, with rounding Assets Liabilities+Capital US Securities 714 Notes 689 Gold 11 Reserve 36.5 SDR’s 2.2 Other 27.7 Forex+other 36.8 Capital 18.8 In collection 5.7 Premises 1.6

24. Expansionary M policy Assets Liabilities US Securities U Reserves Up FRB Check Reserves FRB bond M US Treasury Bond Holder Commercial Bank reserves deposit

25. Money Multiplier • Reserve ratio is currently 10% or 0.1 in USA. • Any bank with reserves greater than 0.1 of its demand deposits (checking accounts) will lend it to another bank. • This reduces the interest rate on reserves. • Eventually banks will “lend up to” the new level of reserves.

26. The Money Multiplier M reserves

27. OMO Steps again OMO→chgR →chgMs →chg‘r’ →chg‘C+I’ →mult chg Y* required reserve ratio Spending multiplier Shape of money demand interest rate sensitivity of spending

28. Money Demand Equation • Let the demand for money be given by Md=P(m0+myY+mrr ) • As an aside it is worth noting here that real money demand is Md/P=(m0+myY+mrr). precautionary transactions speculative and opportunity cost

29. Money Demand Equation • Md=P(m0+myY+mrr ) • A simple example • Md=1(11+(0.1)Y+(-20)r) (we would enter r=0.05 to indicate a 5% rate of interest). If Y=100, P=1 and r=0.05 then Md=20.

30. Money Demand Equation • Md=1(11+(0.1)Y+(-20)r) • If Y=100, P=1 and Ms=20.4 what is r? Md=Ms 1(11+(0.1)100+(-20)r)=20.4 21+-20r=20.4 -20r=20.4-21 -20r=-0.6 r=0.03% An increase in the money supply (from 20 to 20.4) lowered the interest rate

31. How does OMO increase output? • When interest rates fall, investment and consumption, and net exports rise. Our book just simplifies it to investment only. r Id I

32. Chapter 11 Supplement Problem • C=4+(4/5)Yd • Id=20-100r (r is the interest rate) • G=10 • T=5 • M/P=m0+myY+mrr =10+(0.2)Y-100r • P=1 • rr=0.1 (rr is the required reserve ratio) • Y*=120 • Ms=28 • R=2.8 • Original interest rate=0.06 (that’s 6%) How can the FRB close a 5 (billion) dollar GDP gap by lowering their interest rate target? A) what Id? B) what new Id’ ((calculate old Id, since it is not given, and add Id.) C) what new interest rate target for the FRB? D) what is the new money supply? ( To hit the new interest rate target.) E) How much OMO open market operations? (Calculate new level of reserves then find change in reserves).

33. We Think Backwards Thru OMO Steps OMO→chg R →chg Ms → chg ‘r’ → chg Id → chg Y* required reserve ratio Spending multiplier Shape of money demand interest rate sensitivity of spending

34. A) what Id? • C=4+(4/5)Yd • 5 (billion) dollar GDP gap • Relevant givens above GDPgap/(1/1-mpc)=Id 5/(1/(1-(4/5))=Id 5/(1/(1/5))=Id - 5/5=Id 1=Id

35. B) New Id’ for full employment?C) New r for full employment? • Id=20-100r • Original interest rate=0.06 (that’s 6%) • Id=1 Original Id=20-100*0.06=20-6=14 Id’=Id+Id =14+1=15 C) New r? Id=15 = 20-100r 15-20 = -100r -5 = -100r 0.05 = r

36. D) New money supply? ( To hit new interest rate target.) • M/P=m0+myY+mrr =10+(0.2)Y-100r • P=1 • Y*=120 and 5 (billion) dollar GDP gap • 0.05 = r • Yfe=120+5=125 • M’/1=10+(0.2)125-100*0.05=10+25-5=30 • (So R’=30*rr = 30*0.1=3)

37. E) OMO? (find change in reserves). • R=2.8 • R’=3 • OMO=R’-R=3-2.8=0.2 • FRB should buy 0.2 billion $ worth of bonds.

38. Second Monetary Pathway • Suppose that when people have excess money they just spend it on goods, rather than buying bonds. • If so money creation will affect the goods market rather than the bond market. • This tends to happen in hyper inflations.

39. Inflation and Money M: money supply V: velocity of money, or how many times it is used in a year P: price level Y: real output Fast money growth will cause inflation, especially if it causes velocity to increase and output to contract.

40. The relationship between money growth and inflation Note that 300% money growth corresponds to 400% inflation

41. Keynes on Evils of Inflation Tract on Monetary Reform 1923-24 p2.

42. UK Inflation-Deflation Inflation to 1920, deflation there after. Alters the distribution between the Investing Class, Business Class, and Earning Class. Inflation or taxation by currency depreciation: Investing Class Looses 80% of the value of its gov bonds, 1914-1920 This did not help business even though real interest rate was lower: (Tract on Monetary Reform p.24) Deflation or even fear of it reduces employment. (p36-37) So Keynes’ objective was price stability. Book is a plea to focus on internal stability rather than external gold-standard stability.

43. Germany's 1923 hyperinflation • Commanding Heights: Germany's 1923 hyperinflation | on PBS

44. Industrial Inflation and Growth

45. What does money do to growth? • At modest rates of money growth the increase of money stimulates output. • At large rates of growth the money supply causes inflation and reduces output growth.