Money, Interest Rates, and Economic Activity

Chapter 28
Money, Interest
Rates, and
Economic
Activity
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

In this chapter you will learn to
1. Explain why the price of a bond is inversely related to the

market interest rate.
2. Describe how the demand for money is related to the interest
rate, the price level, and real GDP.
3. Explain how monetary equilibrium determines the interest rate in

the short run.
4. Describe the transmission mechanism of monetary policy.
5. Describe the difference between the short-run and long-run

effects of monetary policy.
6. Describe the condition under which monetary policy has the
largest short-run impact on real GDP.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-2
Understanding Bonds
Present Value and the Interest Rate

Present value:
- the value now of one or more payments or receipts
made in the future
Consider an asset that pays $X in one year’s time. If the

interest rate is i% per year, the PV of the asset is
PV = $X/(1+i)
Notice that, ceteris paribus, the PV is negatively related to the
interest rate.
A Sequence of Future Payments
Suppose a $1000 bond pays 10% at the end of each of three

years, at which point it is redeemed. What is the PV if the
interest rate is 7 percent?
PV = $100 + $100 + $1100

1.07 (1.07)2 (1.07)3
More generally,
PV = R1 + R2 + … + R T
(1+i) (1+i)2 (1+i)T
Present Value and Market Price
Consider a competitive market for bonds:
- buyers should be prepared to pay no more than the

bond’s PV
- sellers should be prepared to accept no less than the
bond’s PV
 the equilibrium market price of a bond (or other

financial asset) should be the PV of the stream of
income generated by the bond.

Interest Rates, Market Prices and
Bond Yields
This discussion leads to two important propositions:
1. The PV of a bond is negatively related to the market

interest rate.
2. The market price for a bond should equal its PV.
Since a bond’s yield is inversely related to its price, we

conclude that:
- Market interest rates and bond yields tend to move

together.

Bond Riskiness
An increase in the riskiness of any bond leads to a decline in

its expected PV, and thus to a decline in the bond’s price.
 high risk leads to high yield

The Demand for Money
Reasons for Holding Money
The amount of money that everyone wishes to hold is the

demand for money.
The opportunity cost of holding money is the interest that

could have been earned if the money had been used to
purchase bonds.

The Demand for Money
There are three reasons for holding money:

• the transactions motive
• the precautionary motive
• the speculative motive
The Determinants of Money Demand

We focus on three variables:
• real GDP (+)
• the price level (+)
• the interest rate (-)
Figure 28.1 Money Demand as a
Function of the Interest Rate, Real GDP,
and the Price Level
The MD curve is sometimes

called the liquidity preference
function.
Changes in the interest rate

cause movements along the MD
curve.
Changes in Y or P cause the MD
curve to shift.

The Money Demand Curve
Real GDP
An increase in real GDP increases the volume of transactions
in the economy
 increase in desired money holding
The Price Level

An increase in the price level leads to an increase in the
dollar value of transactions even if there is no change in the
real value of transactions. In order to carry out the same real
value of transactions, as P rises:
 desired money holding increases
Money Demand: Summing Up
– + +
MD = MD (i, Y, P)
Remember there are two assets — bonds and money.
The decision to hold money is the same as the decision

not to hold bonds.

Figure 28.2 Monetary
Equilibrium
Monetary equilibrium
occurs when the quantity
of money demanded
equals the quantity of
money supplied:
 equilibrium interest
rate

The Monetary Transmission
Mechanism
Monetary transmission mechanism:

- connects changes in MD and/or MS with aggregate
demand
Three stages:
1. ΔMD or ΔMS  Δ in equilibrium interest rate

2. Δi  Δ in desired investment expenditure
3. ΔID  Δ in AD

Figure 28.3 Changes in the
Equilibrium Interest Rate

Figure 28.4 The Effects of Changes in
the Money Supply on Desired Investment
Expenditure

Figure 28.5 The Effects of Changes in
the Money Supply on Aggregate Demand
Changes in desired
investment lead to a
shift in the AE
function, and thus a
shift in the AD curve.

Figure 28.6 Summary of the Monetary
Transmission Mechanism

An Open-Economy Modification
In an open economy with mobile financial capital, there is

an extra channel to the transmission mechanism.
As interest rates change, financial capital flows between

countries, putting pressure on the exchange rate.
As the exchange rate changes, net exports change, adding

to the effect on aggregate demand.

Figure 28.7 The Open-Economy
Monetary Transmission Mechanism

The Slope of the AD Curve
In Chapter 23, there were two reasons for the negative slope
of the AD curve:
- ΔP leads to Δwealth
- ΔP leads to ΔNX
We can now add a third reason — the effect of interest rates.
A rise in P leads to:
- an increase in money demand
- a higher interest rate
 reduces desired investment
The Strength of Monetary Forces
Long-Run Neutrality of Money
A shift in the AD curve will lead to different effects in the

short run than in the long run.
In the long run, output eventually returns to Y*.
Money neutrality is the idea that changes in the money

supply do not have real effects on the economy.

Figure 28.8 The Long-Run
Neutrality of Money
What does money

neutrality look like?
-MD shifts up as P and Y

adjust to new long-run
equilibrium
- interest rate returns to its

initial level

Figure 28.9 Inflation and Money
Growth across Many Countries

Short-Run Non-Neutrality of Money
The short-run effect of a change in the money supply

depends on the extent of the shift of the AD curve.
Important debate in the 1950s and 1960s regarding the

effectiveness of monetary policy:
- centered around the slopes of the MD and ID curves
- Keynesians versus Monetarists

Figure 28.10 Two Views on the
Strength of Monetary Changes

Keynesians versus Monetarists
Keynesians argued that monetary policy was not very

effective:
- MD curve was relatively flat
- ID curve was relatively steep
Monetarists argued that monetary policy was very effective:

- MD curve was relatively steep
- ID curve was relatively flat

Empirical Evidence
Today, much empirical support that the money demand

curve is quite steep:
 changes in money supply do lead to changes in

the equilibrium interest rate
 monetary policy can be effective
There is much less compelling evidence regarding the

slope of the investment demand curve.

Money, Interest Rates, and Economic Activity

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Chapter 28

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

1. Explain why the price of a bond is inversely related to the

3. Explain how monetary equilibrium determines the interest rate in

5. Describe the difference between the short-run and long-run

Present Value and the Interest Rate

Consider an asset that pays $X in one year’s time. If the

Suppose a $1000 bond pays 10% at the end of each of three

PV = $100 + $100 + $1100

Consider a competitive market for bonds:

- buyers should be prepared to pay no more than the

 the equilibrium market price of a bond (or other

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-5

This discussion leads to two important propositions:

1. The PV of a bond is negatively related to the market

Since a bond’s yield is inversely related to its price, we

- Market interest rates and bond yields tend to move

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-6

An increase in the riskiness of any bond leads to a decline in

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-7

Reasons for Holding Money

The amount of money that everyone wishes to hold is the

The opportunity cost of holding money is the interest that

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-8

There are three reasons for holding money:

The Determinants of Money Demand

The MD curve is sometimes

Changes in the interest rate

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-10

The Price Level

Remember there are two assets — bonds and money.

The decision to hold money is the same as the decision

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-12

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-13

Monetary transmission mechanism:

1. ΔMD or ΔMS  Δ in equilibrium interest rate

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-14

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-15

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-16

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-17

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-18

In an open economy with mobile financial capital, there is

As interest rates change, financial capital flows between

As the exchange rate changes, net exports change, adding

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-19

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-20

Long-Run Neutrality of Money

A shift in the AD curve will lead to different effects in the

In the long run, output eventually returns to Y*.

Money neutrality is the idea that changes in the money

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-22

What does money

-MD shifts up as P and Y

- interest rate returns to its

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-23

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-24

The short-run effect of a change in the money supply

Important debate in the 1950s and 1960s regarding the

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-25

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-26

Keynesians argued that monetary policy was not very

Monetarists argued that monetary policy was very effective:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 28-27