Economics 302 Sec 001 Intermediate Macroeconomic Theory and Policy Spring 2011 2 9 2011 rev d 2 14 2011 Instructor Prof Menzie Chinn UW Madison 4 1 The Demand for Money y Money which you can use for transactions pays no interest There are two types of money currency coins and d bill bills and d checkable h k bl deposits d it the th b bank kd deposits it 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 mainly i l on ttwo variables i bl Your level of transactions The interest rate on bonds Money market funds pool together the funds of many people The funds are then used to buy bonds typically people bonds typically government bonds 2 of 32 4 1 The Demand for Money Deriving the Demand for Money Let s go from this discussion to an equation describing the Let s demand for money M d Y L i Read this equation in the following way The demand for money M d is equal to nominal income money income Y Y times a function of the interest rate i with the function denoted by L i The demand for money increases in proportion to nominal income Y and depends negatively on the interest rate L i and the negative sign underneath 3 of 32 4 1 The Demand for Money D i i the Deriving th Demand D d for f Money M M d YL i Figure 4 1 The Demand for Money For a given level of nominal income a lower interest rate increases the demand for money At a given interest rate an increase in nominal income shifts the demand for money to the right right 4 of 32 4 2 The Determination of the I Interest Rate R i Money Demand Demand Money Supply Supply and the Equilibrium Interest Rate Equilibrium 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 M Y L i This equilibrium relation is called the LM relation 5 of 32 4 2 Determination of Interest Rate Money Demand M D d M Money S Supply l and d the th Equilibrium E ilib i Interest Rate Figure 4 2 The Determination of the Interest Rate The interest rate must be such that the supply of money which is independent of the interest rate is equal to the demand for moneyy which does depend on the interest rate 6 of 32 4 2 Determination of Interest Rate Money Demand M D d M Money S Supply l and d the th Equilibrium E ilib i Interest Rate Figure 4 3 The Effects of an Increase in Nominal Income on the Interest R t Rate An increase in nominal income leads to an increase in the interest rate 7 of 32 4 2 Determination of Interest Rate Money Demand M D d M Money S Supply l and d the th Equilibrium E ilib i Interest Rate Figure 4 4 The Effects of an Increase in the Money Supply on the Interest R t Rate An increase in the supply of money leads to a decrease in the interest rate 8 of 32 4 2 The Determination of the M Monetary t Policy P li and d Open O Market M k t Operations O ti Interest Rate I Open 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 economies i If the central bank buys bonds this operation is called an expansionary i open market k t operation ti because b th the central bank increases expands the supply of money If If th the central t lb bank k sells ll b bonds d thi this operation ti iis called ll d a contractionary open market operation because the central bank decreases contracts the supply of money 9 of 32 4 2 Determination of Interest Rate M Monetary t Policy P li and d Open O Market M k t Operations O ti Open market operations Fi Figure 4 5 The Balance Sheet of the Central Bank and the Effects of an Expansionary Open Market Operation The assets of the central bank are the bonds it holds holds The liabilities are the stock of money in the economy An open market operation in which the central bank buys bonds and issues money increases both assets and liabilities by the same amount 10 of 32 4 2 Determination of Interest Rate M Monetary t Policy P li and d Open O Market M k t Operations O ti Bond Prices and Bond Yields Understanding U d t di th the relation l ti b between t th the iinterest t t rate t and db bond d prices will prove useful both here and later in this book T Treasury bills bill or T bills T bill are issued i db by th the U U S S governmentt 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 PB PB If we are given the interest rate we can figure out the price of the bond using the same formula formula 100 PB i PB 11 of 32 100 PB 1 i 4 2 Determination of Interest Rate M Monetary t Policy P li and d Open O Market M k t Operations O ti Bond Prices and Bond Yields Let s L t summarize i what h t we h have llearned d so ffar iin thi this chapter h t 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 the money supply by selling bonds lead to a decrease in the price of bonds and an increase in the interest rate 12 of 32 CORRECTED FIGURE ON THIS SLIDE 4 2 Determination of Interest Rate Choosing Money or Choosing the Interest Rate A decision d i i b by th the central t l bank to lower the interest rate from i to i is equivalent to increasing the money supply Figure 4 4 13 of 32 4 2 Determination of Interest Rate Money Bonds and Other Assets We have been looking at an economy with only two assets money and bonds This is obviously a much simplified version of actual economies with their …