Chapter 11 Introduction to the Monetary Intertemporal Model 1 Real and Nominal Interest Rates a What are the features of Nominal Bonds A nominal bond is an asset that sells for one unit of money e g one dollar in the United States in the current period and pays off 1 R units of money in the future period b What is the nominal interest rate The nominal interest rate R is the rate of return on a bond in units of money c What is the Fisher relationship and how is it derived The Fisher relation estimates the relationship between nominal and real interest rates R and r respectively under conditions of inflation i and is given by the following equation 1 r 1 R 1 i So essentially the return on a bond in real terms 1 r is equal to the return on bonds in nominal terms 1 R divided by the gross inflation rate 1 i Furthermore in class it we multiplied the denominator 1 i across the equation and foiled the result giving us R r i ri We then threw away the ri term as it is simply the real interest rate a small decimal multiplied by the inflation rate a small decimal giving us an extremely small and unnecessary number So our end result is R r i 2 Why does the consumer or firms problem remain unchanged when money is introduced The problem remains unchanged because firms and households are assumed to make their decisions in real terms not nominal terms so any changes in the supply of money and the resulting inflation or deflation will have no affect on households a Why do firms and households make decisions in real terms Making decisions in nominal terms is called money illusion and is detrimental to rational economic decision making Firms and households are rational so they make decisions in real terms b What is Money Illusion It is making economic decisions in nominal terms ignoring the changes in inflation So if you are very happy that you get a 5 raise in an economy with 6 inflation you re suffering from money illusion in real terms you have suffered a wage cut as prices overall have increased 3 The Money Market a Money demand curve Why is it upward sloping What causes the money demand curve to shift The money demand curve is upward sloping because price levels and money levels are positively related It s easy to think about it in this way if all prices are zero how much money do you need Of course you ll need zero As prices go up how much money will you need Naturally you will require more money to buy the things you want This results in an upward sloping demand curve The money demand function is defined as M D P L Y R meaning that Y and R shift that curve R can be further broken up by the Fisher relation as being r i so overall the shifters of the MD curve are r i Y Rightward shifts are caused by increases in Y and decreases in r and leftward shifts are caused by decreases in Y and increases in r In situations where both Y and r are increasing or decreasing in the same direction you need to state that one of these changes is dominant and shift the curve in that way b Money supply curve what causes it to shift God Ben Bernanke causes the Ms to shift and nothing else It s exogenous c How do you determine the market clearing price level The market clearing price level is where MS MD after all your shiftings and movings 4 What is the Government Budget Constraint in a monetary economy The government must pay off bonds principal interest from last period and purchase goods for current period and it finances these activities through taxation issuing bonds and printing money This restraint is given by PG In this equation the left side is the outlays PG being the current period spending and the 1 R B term being last period debt and the right side is income PT being current period taxes B being bonds issued to raise money and M M being the growth in money supply with M standing for the quantity of money today and M standing for the quantity of money last period 5 Competitive equilibrium in the Monetary Intertemporal Model He s terrible at laying out outlines so this is apparently a heading for the next five sections 6 Be able to use Graphical Apparatus to analyze events that hit the economy What 7 What happens if the money supply is decreased Decreases in MS shifts that curve line to the left which lowers the price level a Classical Dichotomy Nothing happens to the labor or goods markets so N Y r and w are unchanged in response to a change in the money supply because it is assumed that money that the government prints goes directly to every citizen through tax rebates The price level in money markets however increases dramatically this is the dichotomy that we re talking about here b Neutrality of Money This is what we are assuming here no real variables change in response to changes in the money supply but all nominal quantities change in proportion to the supply change 8 What happens if total factor productivity increases An increase in z shifts the demand for labor to the right and the supply of output to the right This decreases r and increases Y so your MD curve will shift to the right and your labor supply curve will pull back a little to the left a Real Effects That s the whole shifting around of the labor and supply curves in response to a change in z and the resulting decrease in r and increase in Y b Price Level Effects There are none The price level is irrelevant in money neutral analysis 9 Shifts in Money Demand a Sources MD shifts in response to changes in the interest rate and output levels Increases in output and decreases in the interest rate cause MD to shift to the right decreases in output and increases in the interest rate cause MD to shift to the left An easy and intuitive way to remember this is to think of output as the goods we have If we live in a world with a quantity of ten of one product cookies and ten dollars each cookie would cost a dollar If half the cookies disappeared cookies would now cost two dollars i e the price level increases when Y decreases b Neutrality vis vis Real Variables All of our perfectly rational actors don t care about the nominal value of money they just care about the real value Normally a rightward shift in the MD would cause the price level to go down deflation which causes all kinds of horrible things but not here c Price Level effects Price level will decrease when money demand shifts to the right and will increase when money demand shifts to the left …