Introduction To Economics

ECO 100Y

Introduction to Economics Topic 16: The Impact of Money Source: LR12, LR11, Chapter 28; Chapter 29 to pg 705, skim the rest; LR10, Chapter 27; skim rest of Chapter 28. References to open economy and exchange rates will come later; focus on short run only.  

ECO 100 W.G. Wolfson

Topic 16: The Impact of Money

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The Money Market 

There is a market for money:  With a Demand curve  With a Supply curve  With an equilibrium Price

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Special features:  Demand = L = Liquidity Preference  Demand is negatively-sloped (explanation soon!)  Supply = M = Money Supply (M1)  M1 is fixed, until altered by monetary policy  Price = r = Rate of Interest

ECO 100 W.G. Wolfson

Topic 16: The Impact of Money

The Bond Market 

In the Simple Model, households can hold wealth in 2 forms:  Money (which provides no interest return)  (Government) Bonds (which do provide a return)

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Bonds have a price, as determined in the “bond market”  The rate of interest and the bond price are inversely related  As the supply of bonds increases, the bond price will fall and vice versa

Topic 16: The Impact of Money

ECO 100 W.G. Wolfson

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Diagram of the Money Market r

M

r* L

Quantity of Money L, M

ECO 100 W.G. Wolfson

Topic 16: The Impact of Money

Equilibriating Process in the Money Market 

 Excess supply of money  Increases demand for bonds  Bond price rises; r falls

M

r r1 r* r2

 L

L1

ECO 100 W.G. Wolfson

If r1 > r*, then L1<M

L2 L, M

If r2 < r*, then L2>M  Excess demand for money  Increases supply of bonds  Bond price falls; r rises

Topic 16: The Impact of Money

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The Demand For Money 

There are 3 drivers:  Rate of Interest (opportunity cost)  ∆L /∆r < 0  Level of real GDP (size of the economy)  ∆L /∆Y > 0  Price level (inflation)  ∆L /∆P > 0

ECO 100 W.G. Wolfson

Topic 16: The Impact of Money

The Demand For Money (Constant-Price Keynesian Model) 

Keynes provided 3 explanations:  Transactions Demand (to facilitate transactions)  ∆Lp /∆Y > 0  Precautionary Demand (extra, “just in case”)  ∆Lt /∆Y > 0  Speculative Demand (hold money as an asset)  ∆Ls /∆r < 0

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L = Lt + Lp + Ls  L = L(Y, r)

ECO 100 W.G. Wolfson

Topic 16: The Impact of Money

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The Effect of An Increase in M1 (in the Money Market) 

An increase in the Money Supply:  Shifts M to the right  Causes r to fall

r

M1

M2

r1 r2

L

L, M

ECO 100 W.G. Wolfson

Topic 16: The Impact of Money

The Demand for Investment Goods 

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So far, the Investment Demand schedule has been:  I = Constant  I = Constant + MPI*Y Now we recognize that the rate of interest drives I  A lower r reduces the cost of borrowing for capital projects  A lower r reduces the opportunity cost of using retained earnings for capital projects  ∆I /∆r < 0 The I schedule (Marginal Efficiency of Investment) is negatively-sloped (with respect to r)

ECO 100 W.G. Wolfson

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A Lower Interest Rate Affects Investment Demand 

A lower rate of interest:  Encourages greater desired Investment Spending  Movement down the I schedule  Also, may encourage consumers to spend more (not part of our simple model)

ECO 100 W.G. Wolfson

r r1 r2

Topic 16: The Impact of Money

I I1

I2

I

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Higher Desired I Affects Aggregate Expenditure 

As business desired investment spending increases:

Y = AE AE2

AE

 AE shifts up  GDP increases (if Y1
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AE1

A change in the Money Market has caused a change in the Goods/Output Market! Note also that AD shifts to the right (but no change in the price level in the constant-price model)

ECO 100 W.G. Wolfson

Y1

Y2

Y

AE has shifted up by ∆I GDP increases by KI *∆I

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Summary of Monetary Transmission Mechanism 

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How does a change in M affect the real economy?  Money Supply increases  r falls  Lower r  Desired I spending increases  Higher Desired I spending  AE shifts up  Higher AE Schedule  Y increases BUT, there is a (smaller) second-order “Feedback Effect”  As Y increases, so does the Demand for Money (L)  This causes L curve to rise in the Money Market  r does not fall as much, I demand does not rise as much  AE and Y do not rise as much

ECO 100 W.G. Wolfson

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The Effectiveness of Monetary Policy 

For a given change in the Money Supply, by how much will GDP change?  If a large change  very effective  If a small change  relatively ineffective  If no change  totally ineffective

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Demonstrate that effectiveness is determined by 2 factors (Ignore the “feedback effect”):

1. Interest elasticity of L curve 2.Interest elasticity of I curve ECO 100 W.G. Wolfson

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Fiscal Policy and “Crowding Out” 

Two Problems: 1. Show that an increase in government spending (financed by the sale of new bonds to the public) will lead to a higher interest rate, thereby "crowding out" some investment spending, and lowering the value of the KG as computed in the simple Keynesian model presented earlier. (Ignore the “feedback effect”).

2. What kind of "accommodating" monetary policy is necessary if the crowding out effect is to be avoided? ECO 100 W.G. Wolfson

Topic 16: The Impact of Money

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