copyright © 2008 pearson addison-wesley. all rights reserved. chapter 28 money, interest rates, and...

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 28

Money, Interest Rates, and Economic Activity

28-2Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

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.


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


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 = R1 + R2 + … + RT

(1+i) (1+i)2 (1+i)T

A Sequence of Future Payments


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:


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.


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


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


• 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


Figure 28.1 Money Demand as a Function of the Interest Rate, Real GDP, and the Price Level

The MD curve is sometimes called the liquidity preference function.

Changes in the interest rate cause movements along the MD

curve.

Changes in Y or P cause the MD curve to shift.


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


Money Demand: Summing Up

– + +MD = MD (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.


Figure 28.2 Monetary Equilibrium

Monetary equilibrium occurs when the quantity of money demanded equals the quantity of money supplied:

equilibrium interest rate


Monetary transmission mechanism:

- connects changes in MD and/or MS with aggregate demand

Three stages:

1. ΔMD or ΔMS Δ in equilibrium interest rate

2. Δi Δ in desired investment expenditure

3. ΔID Δ in AD

The Monetary Transmission Mechanism


Figure 28.3 Changes in the Equilibrium Interest Rate


Figure 28.4 The Effects of Changes in the Money Supply on Desired Investment Expenditure


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.


Figure 28.6 Summary of the MonetaryTransmission Mechanism


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


Figure 28.7 The Open-Economy Monetary Transmission Mechanism


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


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.


Figure 28.8 The Long-Run Neutrality of Money

What does money neutrality look like?

-MD shifts up as P and Y adjust to new long-run equilibrium

- interest rate returns to its initial level


Figure 28.9 Inflation and Money Growth across Many Countries


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 MD and ID curves

- Keynesians versus Monetarists


Figure 28.10 Two Views on the Strength of Monetary Changes


Monetarists argued that monetary policy was very effective:

- MD curve was relatively steep

- ID curve was relatively flat

Keynesians argued that monetary policy was not very effective:

- MD curve was relatively flat

- ID curve was relatively steep

Keynesians versus Monetarists


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

copyright © 2008 pearson addison-wesley. all rights reserved. chapter 28 money, interest rates, and...

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