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163 11MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL*Key Concepts  The Demand for Money Four factors influence the demand for money: ♦ The price level — An increase in the price level in-creases the nominal demand for money. ♦ The interest rate — An increase in the interest rate raises the opportunity cost of holding money and decreases the quantity of real money demanded. ♦ Real GDP — An increase in real GDP increases the demand for money. ♦ Financial innovation — Innovations that lower the cost of switching between money and other assets decrease the demand for money. Figure 11.1 shows the demand for money curve (MD). The real quantity of money equals the nominal quan-tity divided by the price level. Changes in the interest rate create movements along the demand curve; changes in the other relevant factors change the de-mand and shift the demand curve.  Interest Rate Determination An interest rate is the percentage yield on a financial security; other variables being the same, the higher the price of the security, the lower is the interest rate. The interest rate is determined by the equilibrium in the market for money, as illustrated in Figure 11.2. The real supply of money is $3.0 trillion, so the supply curve of money is MS. The demand curve for money is MD, and the equilibrium interest rate is 5 percent. ♦ If the Fed increases the quantity of money, the supply of money curve shifts rightward and the equilibrium interest rate falls. If the Fed decreases the quantity of money, the supply of money curve shifts leftward and the equilibrium interest rate rises. * This is Chapter 27 in Economics. Chapter164 CHAPTER 11 (27)  Short-Run Effects of Money on Real GDP and the Price Level The Fed’s actions ripple through the economy. Higher interest rates: ♦ Decrease investment and consumption expenditure ♦ Increase the foreign exchange price of the dollar, which then decreases net exports ♦ A multiplier process then occurs Real GDP growth and the inflation rate both slow when the Fed raises the interest rate. The opposite ef-fects occur when the Fed lowers the interest rate. These effects are how the Fed influences the economy. The macroeconomic short run is a period during which some money prices are sticky and real GDP might be below, above, or at potential GDP. If real GDP exceeds potential GDP so there is an infla-tionary gap, the Fed tightens to avoid inflation. The Fed decreases the quantity of money, which raises the interest rate. The higher interest rate decreases interest-sensitive components of aggregate expenditure, such as investment. The decrease in investment leads to a mul-tiplier effect that decreases aggregate demand, thereby lowering the price level and decreasing real GDP so it equals potential GDP. If the Fed eases to avoid a reces-sion, the reverse results occur.  Long-Run Effects of Money on Real GDP and the Price Level The macroeconomic long run is a period that is suffi-ciently long for the forces that move real GDP toward potential GDP to have had their full effects. ♦ Suppose the economy is at its long-run equilibrium and the Fed increases the quantity of money. Ag-gregate demand increases and the AD curve shifts rightward, as illustrated in Figure 11.3. The price level rises, and real GDP increases. ♦ An inflationary gap exists and the unemployment rate is below than the natural rate. The tight labor market leads to a rise in the money wage rate. The short-run aggregate supply decreases, and the short-run aggregate supply curve shifts from SAS0 to SAS1. This situation is illustrated in Figure 11.4, wherein real GDP returns to potential real GDP ($10 trillion) and the price level rises still higher to 130. The quantity theory of money holds that, in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. The velocity of circulation is the average number of times a dollar of money is used in a year to buy goods and services in GDP. In terms of a formula, velocity of circulation, V, is given by V = PY/M, where P is the price level, Y is real GDP, and M is the quantity of money. M1 velocity has increased and fluctuated but M2 velocity has been quite stable.MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL 165 The equation of exchange shows that the quantity of money multiplied by velocity equals (nominal) GDP, or MV = PY. The quantity theory makes two assumptions: ♦ Velocity is not affected by the quantity of money. ♦ Potential GDP is not affected by the quantity of money. With these assumptions, the equation of exchange shows that,MMPP ∆=∆ which means that the percent-age increase in the price level (the inflation rate) equals the percentage increase in the quantity of money. The AS/AD model also predicts that, in the long run, an increase in the quantity of money causes the same percentage increase in the price level. However, the one-to-one relationship does not hold in the short run. Historical evidence from the United States and interna-tional evidence both show that in the long run, the money growth rate and inflation rate are positively related and that the year-to-year relationship is weaker. Helpful Hints 1. USE OF THE QUANTITY THEORY : Analysts often use the quantity theory to help shape their thinking about the future inflation rate by using the rate of growth of the quantity of money to help predict whether the inflation rate is likely to rise or fall. Even though the relationship between the growth rate of the quantity of money and the inflation rate might not be one-to-one as suggested by the quan-tity theory, nonetheless the correlation between higher monetary growth rates and higher inflation rates is quite substantial. You, too, can use this relationship to help predict the inflation rate. For instance, if you note that the growth rate of the quantity of money has jumped sharply higher, you should expect higher inflation rates to occur. Because interest rates tend to in-crease with the inflation rate, you would want to obtain loans with fixed (nominal) interest rates as quickly as possible. Conversely, you would not want to enter into long-term savings contracts with fixed interest rates. Questions  True/False and Explain The Demand for Money 11. The price level is the opportunity cost of holding money. 12. An increase in real GDP increases the demand for money. Interest Rate Determination 13. If the Fed


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UWW ECON 202 - The Demand for Money

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