MONEY INTEREST REAL GDP AND THE PRICE LEVEL

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					MONEY, INTEREST, REAL GDP, AND
       THE PRICE LEVEL
• The demand for money
• Fed influences over interest rates
• Effect of Fed actions on AD, real GDP,
  and the price level in the short run & long
  run
• Quantity theory of money.
     The Demand for Money
• The Determinants of Money Demand
  – The quantity of money that people plan to
    hold depends on four main factors
  – The price level
  – The interest rate
  – Real incomes (Real GDP)
  – Financial innovation
      The Demand for Money
• The price level
  – A rise in the price level
     • increases the nominal quantity of money
       demanded
     • doesn’t change the real quantity of money that
       people plan to hold.
  – 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 Demand for Money
• The interest rate
  – 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.
     The Demand for Money
• 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
• The Demand for Money Curve
  – Shows 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.
   The Demand for Money
– The demand
  for money
  curve slopes
  downward
      The Demand for Money
• Shifts in the Demand for Money Curve
  – Real GDP
  – Financial innovation
 Interest Rate Determination
– An interest rate is the percentage yield on a
  financial security such as a bond or a loan.
– 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.
            The Bond Market.
• Bond features

• Maturity date is the specific future date on which
  the maturity value will be paid to the bond
  holder.
   – Bond maturity dates when issued generally
     range from 3 months up to 30 years.

• Coupon rate
  – Between the date of issuance and the
    maturity date, annual interest payment equals
    the coupon rate times the maturity value.
              The Bond Market.
• Yield to maturity
• the effective interest rate that the bond-holder
  earns if the bond is held to maturity.
• Bond price
• If P=maturity value, bond sells at “par”.
• If P>maturity value, bond sells above “par”.
• Example:
   – Bond that matures 20 years from today with a
     maturity value of $1000 and a coupon rate of
     10% will pay:
   – $100 per year for 20 years
   – $1000 at maturity
   – The bond could be sold at any point in time for
     a price above or below its maturity value.
             The Bond Market.
• Computing yields on one year bonds
• coupon rate = cr, maturity value =mv,
  price = P
• Yield = (MV+cr(MV))/P -1 = MV(1+cr)/P -1
  – As P rises, yield (interest rate) falls.
  – If P=MV (par), yield=cr
  – If P>MV (above par), yield<cr
• What is the yield on a one year bond
  that has a maturity value of 1000 and
  coupon rate of 8% if price equals
  –   $900      $950        $1050
            The Bond Market.
• Computing yields on Zero Coupon Bonds.

• No interest payments are made between the
  sale of the bond and its maturity.

• yield = (MV/P)1/T – 1

• If you buy a zero coupon bond today for
  $1000 and it has a maturity value of $1500 in
  10 years

  – yield = (1500/1000)1/10 -1 = .0414 = 4.14%

• As the price paid for a bond increases, the yield
  (interest rate) falls.
         The Bond Market.
• Determinants of bond yields
  – Risk
    • Debt rating agencies:
          » Moody’s & Standard and Poors
          » AAA=superior quality
          » C=imminent default
     • Inflation risk.
  – Term
    • Longer term bonds have greater inflation
      and default risk.
               The Bond Market.
• Yield curve
   – Shows relationship between yield and term on
     government bonds
   – Slope of yield curve reflects
      • Expectations of future short term interest rates
      • Greater risk of long term bonds
   – If short term interest rates are expected to be constant
     in the future, yield curve will slope upward reflecting
     risk premia for longer term bonds.
   – A steepening of the yield curve suggests that financial
     markets believe short term interest rates will be rising
     in the future.
      • The dynamic yield curve
      • The bond market
   Interest Rate Determination
• 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.
Interest Rate Determination
Interest Rate Determination
– If the Fed
  increases the
  money supply,
  interest rates will
  fall.
– As money supply
  increases, banks
  have more
  loanable funds,
  interest rates are
  reduced.
– Fed has better
  control over short
  term than long
    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:
      1. Investment and consumption expenditures
         decrease.
      2. The value of the $ rises and net exports
         decrease.
      3. A multiplier process unfolds.
Short-Run Effects of Money on
Real GDP, and the Price Level
– The Fed tightens the money supply to reduce
  inflationary pressure. Real GDP decreases
  and the price level falls.
Short-Run Effects of Money on
Real GDP, and the Price Level
– Effects of an Increase in the money supply to
  recover from recession.
 Short-Run Effects of Money on
 Real GDP, and the Price Level
• Limitations of Monetary Stabilization Policy
  – The impact depends on the sensitivity of
    expenditure plans to the interest rate.
  – The effects of monetary policy can take a
    long time be realized.
  – These effects are variable and hard to predict.
LR Effects of Money on Real GDP and the Price Level


 • An increase in the
   money supply will
   increase AD.
 • SR Effects:
    – Real wage falls
    – Unemployment
      falls
    – Real GDP
      increases.
    – Price level
      rises.
LR Effects of Money on Real GDP and the Price Level

 • Movement to new
   LR equilibrium
    – the money wage rate
      rises
    – SAS decreases.
    – RGDP decreases
    – P rises
 • Compared to
   original LR equil.
    – No change in RGDP,
      unempl, real wage
    – Higher prices, nominal
      GDP & nominal wage
Quantity Theory of Money

  – Equation of exchange
        – MV = Py

     – M=money supply
   – V=velocity of money
       – P=price level
        – y=real GDP
     Quantity Theory of Money

                 – MV = PY
– Q-theory assumes that velocity and potential
  GDP are not affected by the quantity of
  money.
                – P = (MV/Y)
– Because (V/Y) does not change when M
  changes, a change in M brings a
  proportionate change in P.
Quantity Theory of Money
     Quantity Theory of Money

               – 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
– M/M is the growth rate of the quantity of
  money.
        Quantity Theory of Money



• Historical Evidence on the Quantity Theory
  of Money
  – U.S. money growth and inflation are correlated
  – more so in the long run than the short run
  – broadly consistent with the quantity theory.
Quantity Theory of Money
   Quantity Theory of Money
Decade averages show stronger relationship
Quantity Theory of Money
   • International Evidence

				
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posted:10/1/2012
language:English
pages:32