Economics 302 (Sec. 001)()Intermediate Macroeconomic Theory and Policy(Spring 2011)Theory and Policy (Spring 2011)2/9/2011 (rev’d 2/14/2011)Instructor: Prof. Menzie ChinnInstructor: Prof. Menzie ChinnUW Madison4-1 The Demand for Moneyy Money, which you can use for transactions, pays no interest. There are two types of money: currency, coins d bill dhkbld itth b k d itand bills, and checkable deposits, the bank deposits on which you can write checks.  Bonds pay a positive interest rate, i, but they cannot be used for transactions.The proportions of money and bonds you wish to hold depend il t iblmainly on two variables: Your level of transactionsThe interest rate on bondsThe interest rate on bondsMoney market funds pool together the funds of many people The funds are then used to buy bonds—typically2of 32people. The funds are then used to buy bondstypically government bonds.4-1 The Demand for MoneyLet’s go from this discussion to an equation describing theDeriving the Demand for MoneyLet s go from this discussion to an equation describing the demand for money.$()dMYLi=()()−Read this equation in the following way: The demand for money is equal to nominal income $Y times a functiondMmoney, , is equal to nominal income, $Y, times a function of the interest rate, i, with the function denoted by L(i ).M•The demand for money:– increases in proportion to nominal income ($Y), and–depends negatively on the interest rate (L(i) and the3of 32depends negatively on the interest rate (L(i) and the negative sign underneath).4-1 The Demand for MoneyDii thD df MMYLid=$()Deriving the Demand for MoneyMYLi$()()−Figure 4 - 1For a given level of nominal income, a lower interest rate increases the demand for The Demand for Moneyincreases the demand for money. At a given interest rate, an increase in nominal income shifts the demand for money to the rightthe right.4of 324-2 The Determination of the IRiInterest Rate, iMoney Demand Money Supply and the EquilibriumMoney Demand, Money Supply, and the Equilibrium Interest RateEquilibrium in financial markets requires that money supplyEquilibrium in financial markets requires that money supply be equal to money demand, or that Ms= Md. Then using this equation, the equilibrium condition is:Money Supply = Money demand$()MYLiThis equilibrium relation is called the LM relation.$()MYLi=5of 324-2 Determination of Interest RateM D d M S l d th E ilib iFigure 4-2Money Demand, Money Supply, and the Equilibrium Interest RateThe interest rate must be such The Determination of the Interest RateFigure 4 2that the supply of money (which is independent of the interest rate) is equal to the demand for money (which does y(depend on the interest rate). 6of 324-2 Determination of Interest RateM D d M S l d th E ilib iMoney Demand, Money Supply, and the Equilibrium Interest RateFigure 4-3The Effects of an Increase in Nominal Income on the Interest RtFigure 4 3An increase in nominal income leads to an increase in the interest rate.Rateinterest rate.7of 324-2 Determination of Interest RateM D d M S l d th E ilib iMoney Demand, Money Supply, and the Equilibrium Interest RateFigure 4-4The Effects of an Increase in the Money Supply on the Interest RtFigure 4 4An increase in the supply of money leads to a decrease in the interest rate.Ratethe interest rate.8of 324-2 The Determination of the MtPli dO MktO tiInterest Rate, IMonetary Policy and Open Market OperationsOpen market operations•Open-market operations, which take place in the “open market” for bonds, are the standard method central banks use to change the money stock in modern ieconomies.•If the central bank buys bonds, this operation is called ikttibthan expansionary open market operationbecause the central bank increases (expands) the supply of money.If th t l b k ll b d thi ti i ll d•If the central bank sells bonds, this operation is called a contractionary open market operation because the central bank decreases (contracts) the supply of money.9of 324-2 Determination of Interest RateMtPli dO MktO tiMonetary Policy and Open Market OperationsOpen market operationsFi 45The Balance Sheet of the Central Bank and the Effects of an Figure 4 -5The assets of the central bank are the bonds it holds The Expansionary Open Market Operationare the bonds it holds. The liabilities are the stock of money in the economy. An open market operation in which the central bank buys bonds the central bank buys bonds and issues money increases both assets and liabilities by the same amount. 10 of 324-2 Determination of Interest RateMtPli dO MktO tiU d t di th l ti b t th i t t t d b dMonetary Policy and Open Market OperationsBond Prices and Bond YieldsUnderstanding the relation between the interest rate and bond prices will prove useful both here and later in this book:T billTbillidbthUS tTreasury bills, or T-bills are issued by the U.S. government promising payment in a year or less. If you buy the bond today and hold it for a year, the rate of return (or interest) on holding a $100 bond for a year is ($100$P)/$Pholding a $100 bond for a year is ($100 -$PB)/$PB. If we are given the interest rate, we can figure out the price of the bond using the same formulaiPB=−$100 $⇒$$100PB=of the bond using the same formula.11 of 32iPB=$⇒$iB+14-2 Determination of Interest RateMtPli dO MktO tiLt’ i ht h l d f i thi h tMonetary Policy and Open Market OperationsBond Prices and Bond YieldsLet’s summarize what we have learned so far in this chapter: The interest rate is determined by the equality of the supply of money and the demand for money. By changing the supply of money, the central bank can affect the interest rate. The central bank changes the supply of money through open market operations, which are purchases or sales of bonds for money. Open market operations in which the central bank increases the money supply by buying bonds lead to an increase in the price of bonds and a decrease in the interest rate. Open market operations in which the central bank decreases 12 of 32the money supply by selling bonds lead to a decrease in the price of bonds and an increase in the interest rate.4-2 Determination of Interest RateCORRECTED FIGURE ON THIS SLIDEAd i i b th t lChoosing Money or Choosing the Interest Rate?A decision by the central bank to lower the interest rate from i to i ’ is equivalent to increasing the moneyto increasing the money supply.Figure 4 - 413 of