9 - ch27 Money, Interest, Real GDP, and The Price Level

Objectives
After studying this chapter, you will able to

 Explain what determines the demand for money
 Explain how the Fed influences interest rates
 Explain how the Fed’s actions influence spending plans,
real GDP, and the price level in the short run
 Explain how the Fed’s actions influence real GDP and
the price level in the long run and explain the quantity
theory of money
Ripple Effects of Money
There is enough money in the United States today for

everyone to have a wallet stuffed with $2,300 in notes and
coins and another $19,000 in the bank.
Why do we hold so much money?
Through 2001, as the economy slowed, the Fed cut
interest rates 11 times.
In 2002 and 2003, the Fed cut the interest rate even
further to historically low levels.
How does the Fed change the interest rate and with what
effects?
The Demand for Money
The Influences on Money Holding

The quantity of money that people plan to hold depends
on four main factors
 The price level
 The interest rate
 Real GDP
 Financial innovation
The price level

A rise in the price level increases the nominal quantity of
money but doesn’t change the real quantity of money that
people plan to hold.
Nominal money is the amount of money measured in
dollars.
The quantity of nominal money demanded is proportional
to the price level — a 10 percent rise in the price level
increases the quantity of nominal money demanded by 10
percent.
The interest rate

The interest rate is the opportunity cost of holding wealth
in the form of money rather than an interest-bearing asset.
A rise in the interest rate decreases the quantity of money
that people plan to hold.
Real GDP
An increase in real GDP increases the volume of
expenditure, which increases the quantity of real money
that people plan to hold.
Financial innovation
Financial innovation that lowers the cost of switching
between money and interest-bearing assets decreases the
quantity of money that people plan to hold.
The Demand for Money Curve

The demand for money curve is the relationship between
the quantity of real money demanded (M/P) and the
interest rate when all other influences on the amount of
money that people wish to hold remain the same.
Figure 27.1 illustrates the

demand for money curve.
The demand for money
curve slopes downward
A fall in the interest rate
lowers the opportunity cost
of holding money and
brings an increase in the
quantity of money
demanded--a movement
downward along the
demand for money curve.
A rise in the interest rate

increases the opportunity
cost of holding money and
brings an decrease in the
quantity of money
demanded--a movement
upward along the demand
for money curve.
Shifts in the Demand for Money Curve

The demand for money changes and the demand for
money curve shifts if real GDP changes or if financial
innovation occurs.
Figure 27.2 illustrates an

increase and a decrease in
the demand for money.
A decrease in real GDP or
a financial innovation
decreases the demand for
money and shifts the
demand curve leftward.
An increase in real GDP
increases the demand for
money and shifts the
demand curve rightward.
The Demand for Money in

the United States
Figure 27.3 shows scatter
diagrams of the interest
rate against real M1 and
real M2 from 1970 through
2003 and interprets the
data in terms of
movements along and
shifts in the demand for
money curves.
The Demand for Money in

the United States
Figure 27.3 shows scatter
diagrams of the interest
rate against real M1 and
real M2 from 1970 through
2003 and interprets the
data in terms of
movements along and
shifts in the demand for
money curves.
Interest Rate Determination
An interest rate is the percentage yield on a financial

security such as a bond or a stock.
The price of a bond and the interest rate are inversely
related.
If the price of a bond falls, the interest rate on the bond
rises.
If the price of a bond rises, the interest rate on the bond
falls.
We can study the forces that determine the interest rate in
the market for money.
Money Market Equilibrium

The Fed determines the quantity of money supplied and
on any given day, that quantity is fixed.
The supply of money curve is vertical at the given quantity
of money supplied.
Money market equilibrium determines the interest rate.

equilibrium interest rate.
If the interest rate is

above the equilibrium
interest rate, the quantity
of money that people are
willing to hold is less than
the quantity supplied.
They try to get rid of their
“excess” money by
buying financial assets.
This action raises the
price of these assets and
lowers the interest rate.
If the interest rate is below

the equilibrium interest
rate, the quantity of money
that people want to hold
exceeds the quantity
supplied.
They try to get more
money by selling financial
assets.
This action lowers the
price of these assets and
raises the interest rate.
Changing the Interest

Rate
Figure 27.5 shows how the
Fed changes the interest
rate.
If the Fed conducts an
open market sale, the
money supply decreases,
the money supply curve
shifts leftward, and the
interest rate rises.
If the Fed conducts an

open market purchase, the
money supply increases,
the money supply curve
shifts rightward, and the
interest rate falls.
Short-Run Effects of Money on
Real GDP, and the Price Level
Ripple Effects of Monetary Policy

If the Fed increases the interest rate, three events follow:
 Investment and consumption expenditures decrease.
 The dollar rises and next exports decrease.
 A multiplier process unfolds.
Figure 27.6 summarizes

these ripple effects.
The Fed Tightens to Avoid Inflation

Figure 27.7 illustrates the attempt to avoid inflation.
A decrease in the money supply in part (a) raises the

interest rate.
The rise in the interest rate decreases investment in

part (b).
The decrease in investment shifts the AD curve leftward

with a multiplier effect in part (c).
Real GDP decreases and the price level falls.

The Fed Eases to Avoid Recession

Figure 27.8 illustrates the attempt to avoid recession.
An increase in the money supply in part (a) lowers the

interest rate.
The fall in the interest rate increases investment in part (b).

The increase in investment shifts the AD curve rightward

with a multiplier effect in part (c).
Real GDP increases and the price level rises.

The size of the multiplier effect of monetary policy

depends on the sensitivity of expenditure plans to the
interest rate.
Limitations of Monetary Stabilization Policy
Monetary policy shares the limitations of fiscal policy,
except that there is no law-making time lag or uncertainty.
It also has the additional limitation that the effects of
monetary policy are long drawn out, indirect, and depend
on responsiveness of spending to interest rates.
These effects are all variable and hard to predict.
Long-Run Effects of Money on
Real GDP and the Price Level
In the long run, real GDP equals potential GDP.

An increase in the quantity of money at full employment
increases real GDP and raises the price level.
The money wage rate rises, which decreases short-run
aggregate supply and decreases real GDP but raises the
price level.
In the long run, an increase in the quantity of money
leaves real GDP unchanged but raises the price level.

effects of an increase in
the quantity of money
starting from potential
GDP.
In part (a), the Fed
increases the quantity of
money and lowers the
interest rate.
In part (b), aggregate

demand increases
Real GDP increases to
$10.2 trillion and the price
level rises to 105.
With an inflationary gap,

the money wage rate rises
and short-run aggregate
supply decreases.
The SAS curve shifts
leftward, real GDP
decreases to $10 trillion
and the price level rises to
110.
Back in the money

market, the rise in the
price level decreases the
quantity of real money.
The interest rate rises to 6
percent.
The Quantity Theory of Money

The quantity theory of money is the proposition that, in
the long run, an increase in the quantity of money brings
an equal percentage increase in the price level.
The quantity theory of money is based on the velocity of
circulation and the equation of exchange.
The velocity of circulation is the average number of
times in a year a dollar is used to purchase goods and
services in GDP.
Calling the velocity of circulation V, the price level P, real

GDP Y, and the quantity of money M
V = PY/M.
Figure 27.10 on the next slide graphs the velocity of
circulation for M1 and M2 for 1963–2003.
The equation of exchange states that
MV = PY
The quantity theory assumes that velocity and potential
GDP are not affected by the quantity of money.
So
P = (V/Y)M
Because (V/Y) does not change when M changes, a
change in M brings a proportionate change in P.
That is, the change in P, P, is related to the change in M,
M, by the equation:
P = (V/Y) M
Divide this equation by
P = (V/Y)M
and the term (V/Y) cancels to give
P/P = M/M
P/P is the inflation rate and = M/M is the growth rate of
the quantity of money.
Historical Evidence on the Quantity Theory of Money

Historical evidence shows that U.S. money growth and
inflation are correlated, more so in the long run than the
short run, which is broadly consistent with the quantity
theory.
Figure 27.11
graphs money
growth and
inflation in the
United States
from 1963 to
2003.
Part (a) shows
year-to-year
changes.
Part (b) shows

decade
average
changes.
International Evidence on
the Quantity Theory of
Money
International evidence
shows a marked tendency
for high money growth rates
to be associated with high
inflation rates.
Figure 27.12 shows the
evidence.
Correlation, Causation, and Other Influences

Correlation is not causation; money growth and inflation
could be correlated because money growth causes
inflation, or because inflation causes money growth, or
because a third factor caused both.
But the combination of historical, international, and other
independent evidence gives us confidence that in the long
run, money growth causes inflation.
In the short run, the quantity theory is not correct; we need
the AS-AD model.

9 - ch27 Money, Interest, Real GDP, and The Price Level

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Objectives

After studying this chapter, you will able to

There is enough money in the United States today for

The Influences on Money Holding

The price level

The interest rate

The Demand for Money Curve

Figure 27.1 illustrates the

A rise in the interest rate

Shifts in the Demand for Money Curve

Figure 27.2 illustrates an

The Demand for Money in

The Demand for Money in

An interest rate is the percentage yield on a financial

Money Market Equilibrium

Figure 27.4 illustrates the

If the interest rate is

If the interest rate is below

Changing the Interest

If the Fed conducts an

Ripple Effects of Monetary Policy

Figure 27.6 summarizes

The Fed Tightens to Avoid Inflation

A decrease in the money supply in part (a) raises the

The rise in the interest rate decreases investment in

The decrease in investment shifts the AD curve leftward

Real GDP decreases and the price level falls.

The Fed Eases to Avoid Recession

An increase in the money supply in part (a) lowers the

The fall in the interest rate increases investment in part (b).

The increase in investment shifts the AD curve rightward

Real GDP increases and the price level rises.

The size of the multiplier effect of monetary policy

In the long run, real GDP equals potential GDP.

Figure 27.9 illustrates the

In part (b), aggregate

With an inflationary gap,

Back in the money

The Quantity Theory of Money

Calling the velocity of circulation V, the price level P, real

The equation of exchange states that

Historical Evidence on the Quantity Theory of Money

Part (b) shows

Correlation, Causation, and Other Influences

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