Chapter 26: The Monetary Policy

26-1 The Keynesian View of the Role of Money

26-1a The Demand for Money

Why do people hold (demand) currency and checkable deposits (M1), rather than put their money to work in stocks, bonds, real estate, or other nonmoney forms of wealth? Because money yields no direct return, people (including businesses) who hold cash or checking account balances incur an opportunity cost of forgone interest or profits on the amount of money held. So what are the benefits of holding money? Why would people hold money and thereby forgo earning interest payments? John Maynard Keynes, in his 1936 book The General Theory of Employment, Interest, and Money, gave three important motives for doing so: transactions demand, precautionary demand, and speculative demand.

Transactions Demand for Money

The first motive to hold money is the transactions demand. The transactions demand for moneytransactions demand for moneyThe stock of money people hold to pay everyday predictable expenses.is the stock of money people hold to pay everyday predictable expenses. The desire to have “walking around money” to make quick and easy purchases is the principal reason for holding money. Students, for example, have a good idea of how much money they will spend on rent, groceries, utilities, gasoline, and other routine purchases. A business can also predict its payroll, utility bills, supply bills, and other routine expenses. Without enough cash, the public must suffer forgone interest and possibly withdrawal penalties as a result of converting their stocks, bonds, or certificates of deposit into currency or checkable deposits in order to make transactions.

Precautionary Demand for Money

In addition to holding money for ordinary expected purchases, people have a second motive to hold money, called the precautionary demand. The precautionary demand for moneyprecautionary demand for moneyThe stock of money people hold to pay unpredictable expenses.is the stock of money people hold to pay unpredictable expenses. This is the “mattress money” people hold to guard against those proverbial rainy days. For example, your car might break down, or your income may drop unexpectedly. Similarly, a business might experience unexpected repair expenses or lower-than-anticipated cash receipts from sales. Because of unforeseen events that could prevent people from paying their bills on time, people hold precautionary balances. This affords the peace of mind that unexpected payments can be made without having to cash in interest-bearing financial assets or to borrow.

Speculative Demand for Money

The third motive for holding money is the speculative demand. The speculative demand for moneyspeculative demand for moneyThe stock of money people hold to take advantage of expected future changes in the price of bonds, stocks, or other nonmoney financial assets.is the stock of money people hold to take advantage of expected future changes in the price of bonds, stocks, or other nonmoney financial assets. In addition to the transactions and precautionary motives, individuals and businesses demand “betting money” to speculate, or guess, whether the prices of alternative assets will rise or fall. This desire to take advantage of profit-making opportunities when the prices of nonmoney assets fall is the driving force behind the speculative demand. When the interest rate is high, people buy, say, Microsoft 30-year bonds because the opportunity cost of holding money is the high forgone interest earned on

these nonmoney assets. When the interest rate is low, people hold more money because there is less opportunity cost in forgone interest earned on investing in bonds. Suppose the interest rate on Microsoft 30-year bonds is low. If so, people decide to hold more of their money in the bank and speculate that soon the interest rate will climb higher.

Conclusion: As the interest rate falls, the opportunity cost of holding money falls, and people increase their speculative balances.

The Demand for Money Curve

The three motives for holding money combine to create a demand for money curve demand for money curveA curve representing the quantity of money that people hold at different possible interest rates, ceteris paribus., which represents the quantity of money people hold at different possible interest rates, ceteris paribus. As shown in Exhibit 1, people increase their money balances when interest rates fall. The reason is that many people move their money out of, for example, money market mutual funds and into checkable deposits (M1).

Exhibit 1: The Demand for Money Curve

Assume the level of real GDP is $5,000 billion. Also assume households and businesses demand to hold 10 percent of real GDP ($500 billion) for transactions and precautionary balances. The speculative demand for money varies inversely with the interest rate. At an interest rate of 4 percent, the quantity of money demanded (M1) is $1,000 billion (point A), calculated as the sum of transactions and precautionary demand ($500 billion) and speculative demand ($500 billion). At a lower interest rate, a greater total quantity of money is demanded because the opportunity cost of holding money is lower.

Conclusion: There is an inverse relationship between the quantity of money demanded and the interest rate.

What determines the shape of the demand for money curve? It start with the transactions and the precautionary demands for money. These money balances are computed as a given proportion of real GDP. Suppose real GDP is $5,000 billion and people wish to hold, say, 10 percent for transactions and precautionary purposes. This means the first $500 billion read along the horizontal axis in Exhibit 1 are held to make purchases and handle unforeseen events.

Now consider the impact of changes in the interest rate on the speculative demand for money. As the interest rate falls, people add larger speculative balances to their transactions and precautionary balances. For example, when the rate is 4 percent per year, the total quantity of money demanded at point A is $1,000 billion, of which $500 billion are speculative balances. If the interest rate is 2 percent, the total quantity of money demanded increases to $1,500 billion at point B, of which $1,000 billion are speculative balances. Therefore, the demand for money curve, labeled “MD,” looks much like any other demand curve.

Conclusion: The speculative demand for money at possible interest rates gives the demand for money curve its downward slope.

26-1b The Equilibrium Interest Rate

We are now ready to form the money market and determine the equilibrium interest rate by putting the demand for money and the supply of money together. In Exhibit 2, the money demand curve (MD) is identical to that in Exhibit 1. The supply of money curve (MS) is a vertical line because the $1,000 billion quantity of money supplied does not respond to changes in the interest rate. The reason is that our model assumes the Fed has used its tools to set the money supply at this quantity of money regardless of the interest rate.

At point E, the equilibrium interest rate is 8 percent, determined by the intersection of the demand for money curve and the vertical supply of money curve. People wish to hold exactly the amount of money in circulation, therefore, there is neither upward nor downward pressure on the interest rate.

Exhibit 2The Equilibrium Interest Rate

The money market consists of the demand for and the supply of money. The market demand curve represents the quantity of money people are willing to hold at various interest rates. The money supply curve is a vertical line at $1,000 billion, based on the assumption that this is the quantity of money supplied by the Fed. The equilibrium interest rate is 4 percent and occurs at the intersection of the money demand and money supply curves (point E). At any other interest rate, for example, 6 percent or 2 percent, the quantity of money people desire to hold does not equal the quantity available.

SOURCE: © Cengage Learning 2014

Excess Quantity of Money Demanded

Suppose the interest rate in Exhibit 2 is 2 percent instead of 4 percent. Such a low opportunity cost of money means that people desire to hold a greater quantity of money than the quantity supplied. To eliminate this shortage of $500 billion, individuals and businesses adjust their asset portfolios. They seek more money by selling their bonds or other nonmoney assets. When many sell or try to sell their bonds, there is an increase in the supply of bonds for sale. Consequently, the price of bonds falls, and the interest rate rises. This rise in the interest rate ceases at the equilibrium interest rate of 4 percent because people are content with their portfolio of money and bonds at point E.

Here we need to pause and look at an example to understand what is happening. Suppose Apple pays 2 percent on its $1,000 30-year bonds. This means Apple pays a bondholder $20 in interest each year and promises to repay the original $1,000 price (face amount) at the end of 30 years. However, a holder of these bonds can sell them before maturity at a market-determined price. If bondholders desire to hold more money than is supplied, they will sell more of these bonds. Then the increase in the supply of bonds causes the price of bonds to fall to, say, $500. As a result, the interest rate rises to 4 percent ($20/$500).

Excess Quantity of Money Supplied

The story reverses for any rate of interest above 4 percent. Let’s say the interest rate is 6 percent. In this case, people are holding more money than they wish. Stated differently, they wish to hold less money than is currently in circulation. In this case, the quantity of money demanded is $250 billion less than the quantity supplied. To correct this imbalance, people will move out of cash and checkable deposits by buying bonds. This increase in the demand for bonds will drive up the price of bonds and lower the interest rate. As the interest rate falls, the quantity of money demanded increases as people become more willing to hold money. Finally, the money market reaches equilibrium at point E, and people are content with their mix of money and bonds.

Conclusion: There is an inverse relationship between bond prices and the interest rate that enables the money market to achieve equilibrium.

26-1c How Monetary Policy Affects the Interest Rate

Assuming a stationary demand for money, the equilibrium rate of interest changes in response to changes in monetary policy. As we learned in Exhibit 4 of the previous chapter, the Federal Reserve can alter the money supply through open market operations, changes in the required reserve ratio, or changes in the discount rate. In this section, you will see that the Fed’s power to change the money supply can also alter the equilibrium rate of interest.

Increasing the Money Supply

Exhibit 3(a) shows how increasing the money supply will cause the equilibrium rate of interest to fall. Our analysis begins at point E1, with the money supply at $1,000 billion, which is equal to the quantity of money demanded, and with the equilibrium interest rate at 6 percent. Now suppose the Fed increases the money supply to $1,500 billion by buying government securities in the open market. The impact of the Fed’s expansionary monetary policy is to create a $500 billion surplus of money at the prevailing 6 percent interest rate.

Exhibit 3The Effect of Changes in the Money Supply

In part (a), the Federal Reserve increases the money supply from $1,000 billion (MS1) to $1,500 billion (MS2). At the initial interest rate of 6 percent (point E1), there is an excess of $500 billion beyond the amount people wish to hold. They react by buying bonds, and the interest rate falls until it reaches a new lower equilibrium interest rate at 4 percent (point E2).The reverse happens in part (b). The Fed decreases the money supply from $1,500 billion (MS1) to $1,000 billion (MS2). Beginning at 4 percent (point E1), people wish to hold $500 billion more than is available. This shortage disappears when people sell their bonds. As the price of bonds falls, the interest rate rises to the new higher equilibrium interest rate of 6 percent at point E2.

SOURCE: © Cengage Learning 2014

How will people react to this excess money in their pockets or checking accounts? Money becomes a “hot potato,” and people buy bonds. The rush to purchase bonds drives the price of bonds higher and the interest rate lower. As the interest rate falls, people are willing to hold larger money balances. Or, stated differently, the quantity of money demanded increases until the new equilibrium at E2 is reached. At the lower interest rate of 8 percent, the opportunity cost of holding money is also lower, and the imbalance between the money demand and money supply curves disappears.

Decreasing the Money Supply

Exhibit 3(b) illustrates how the Fed can put upward pressure on the interest rate with contractionary monetary policy. Beginning at point E1, the money market is in equilibrium at an interest rate of 4 percent. This time the Fed shrinks the money supply by selling government securities through its trading desk, raising the required reserve ratio, or raising the discount rate. As a result, the money supply decreases from $1,500 billion to $1,000 billion. At the initial equilibrium interest rate of 4 percent, this decrease in the money supply causes a shortage of $500 billion.

Individuals and businesses wish to hold more money than is available. How can the public put more money in their pockets and checking accounts? They can sell their bonds for cash. This selling pressure lowers bond prices, causing the rate of interest to rise. At point E2, the upward pressure on the interest rate stops. Once the equilibrium interest rate reaches 6 percent, people willingly hold the $1,000 billion money supply.

26-1d How Monetary Policy Affects Prices, Output, and Employment

The next step in our journey is to understand how monetary policy alters the macro economy. Here you should pause and study Exhibit 4. This exhibit illustrates the causation chain linking monetary policy and economic performance.

Exhibit 4The Keynesian Monetary Policy Transmission Mechanism

Keynesians focus on how changes in the money supply affect interest rates and investment spending. In turn, aggregate demand shifts and affects prices, real GDP, and employment.

SOURCE: © Cengage Learning 2014

Conclusion: In the Keynesian model, changes in the supply of money affect interest rates. In turn, interest rates affect investment spending, aggregate demand, and, finally, real GDP, employment, and prices.

The Impact of Monetary Policy Using the AD-AS Model

How do changes in the rate of interest affect aggregate demand? Begin with Exhibit 5(a), which is identical to Exhibit 3(a) and represents the money market. As explained earlier, we assume that the Fed increases the money supply from $1,000 billion (MS1) to $1,500 billion (MS2) and the equilibrium interest rate falls from 6 percent to 4 percent. In part (b), we can see that the falling rate of interest causes an increase in the quantity of investment spending from $800 billion to $850 billion per year. Stated another way, there is a movement downward along the investment demand curve (I), which you recall from the chapter on GDP is a component of total spending or aggregate demand. The investment demand curve shows the amount businesses spend for investment goods at different possible interest rates.

Exhibit 5The Effect of Expansionary Monetary Policy on Aggregate Demand

In part (a), the money supply is initially MS1, and the equilibrium rate of interest is 6 percent. The equilibrium point in the money market changes from E1 to E2 when the Fed increases the money supply to MS2. This causes the quantity of money people wish to hold to increase from $1,000 billion to $1,500 billion, and a new lower equilibrium interest rate is established at 4 percent.The fall in the rate of interest shown in part (b) causes a movement downward along the investment demand curve from point A to point B. Thus, the quantity of investment spending per year increases from $800 billion to $850 billion.In part (c), the investment component of the aggregate demand curve increases, causing this curve to shift outward from AD1 to AD2. As a result, the aggregate demand and supply equilibrium in the product market changes from E1 to E2, and the real GDP gap is eliminated. The price level also changes from 210 to 215.

SOURCE: © Cengage Learning 2014

The classical economists believed that the interest rate alone determines the level of investment spending. Keynes disputed this idea. Instead, Keynes argued that the expectation of future profits is the primary factor determining investment and the interest rate is the financing cost of any investment proposal. Using a micro example to illustrate the investment decision-making process, suppose a consulting firm plans to purchase a new computer program for $1,000 that will be obsolete in a year. The firm anticipates the new software will increase its revenue by $1,100. Thus, assuming no taxes and other expenses, the expected rate of return or profit is 10 percent.Now consider the impact of the cost of borrowing funds to finance the software investment. If the interest rate is less than 10 percent, the business will earn a profit, and it will make the investment expenditure to obtain the computer program. On the other hand, a rate of interest higher than 10 percent means the software investment will be a loss, so this purchase will not be made. The expected rate of the profit-interest rate-investment relationship follows this rule: Businesses will undertake all investment projects for which the expected rate of profit equals or exceeds the interest rate.

Exhibit 5(c) uses the fiscal policy aggregate demand and aggregate supply analysis developed earlier. Begin at point E1, with a real GDP per year of $13 trillion and a price level of 210. Now consider the link to the change in the money supply. The increase in investment resulting from the fall in the interest rate works through the spending multiplier and shifts the aggregate demand curve rightward from AD1 to AD2. At the new equilibrium point, E2, the level of real GDP rises from $13 trillion to $14 trillion, and full employment is achieved. In addition, the price level rises from 210 to 215. Exhibit 5(a) also demonstrates the effect of a contractionary monetary policy. In this case, assume the economy is initially at E2 and the money supply shifts inward from MS2 to MS1, causing the equilibrium rate of interest to rise from 4 percent to 6 percent. The Fed’s “tight” money policy causes the level of investment spending to fall from $850 billion to $800 billion, which, in turn, decreases the equilibrium level of real GDP per year from $14 trillion to $13 trillion. As a result, the unemployment rate rises, and the inflation rate falls because the price level falls from 215 to 210.