24ECA001 - Lecture 3 and 4

24ECA001 Principles of Macroeconomics

• Money Demand, Interest Rates and Monetary Policy Transmission

• Developed by Sinchan Mitra

References

• Primary Reference: "Economics (12th edition)" by David Begg et al., Chapter 22.

• Additional Reading: "Economics" by Lipsey and Chrystal, 13th edition, Chapter 19.

• Assigned adaptive reading on Connect for additional insights.

The Demand for Money

• Conceptual Framework:

  • Two primary assets: Money and Bonds.

    • Money: Liquid asset, used as a medium of exchange.

    • Bonds: Interest-bearing asset, provides a return but not used directly for transactions.

• Reasons for Holding Money:

  • Provides liquidity for transactions without transaction costs.

  • Universally accepted as payment.

• Reasons for Holding Bonds:

  • Provides financial returns through the interest rate.

Money Demand Determinants

• Holding money depends on:

  • Frequency of transactions.

  • Institutional and technological factors.

• Nominal GDP as a Metric:

  • Nominal money demand (Md) correlates to nominal GDP (Py).

  • Real money demand (Md/P) relates to real GDP (y).

• Interest Rate Effects:

  • Higher interest rates on bonds increase opportunity costs of holding money, therefore decreasing money demand.

  • Real money demand increases with rising real income and decreases as interest rates rise.

Money Market Equilibrium

• Role of Central Bank:

  • Central banks control nominal money supply (high powered money).

  • In the short run, they control the real money supply if prices are rigid.

  • Over the long run, with flexible prices, real money supply is not directly determined.

• Graphical Representation (22.1):

  • Demand curve (LL) for real money balances shows less demand with higher interest rates.

  • Equilibrium occurs when the supply of real money equals demand at interest rate (io).

Adjustments to Equilibrium

• If interest rate is i1, excess demand for money implies excess supply of bonds:

  • Bond suppliers raise interest rates, reducing bond excess supply and money excess demand.

  • Target equilibrium is achieved when the market adjusts back to i0.

Central Bank’s Monetary Policy Approach

• Central banks often set interest rates rather than target money supply directly:

  • This allows for market-driven adjustments to achieve desired interest rates.

  • Central bank adjusts the monetary base to meet the interest rate target, impacting the money supply passively.

Reasons for Interest Rate Focus

• Modern central banks favor interest rates due to:

  • Uncertainty about money multipliers.

  • Unpredictability of money demand due to diverse non-money assets.

• Directly setting interest rates provides better control for monetary policy effectiveness.

Effects of Monetary Policy on the Economy

• In a Closed Economy:

  • Monetary policy influences aggregate demand through interest rate adjustments.

• Relationship between interest rates and consumption:

  • Lower interest rates increase the present value of future earnings, boosting corporate share prices.

  • This wealth effect increases consumer spending.

Expansionary Monetary Policy Impact

• Expands availability of credit and lowers borrowing costs.

• For long-term investments, expectations of future short-term rates impact decisions over time.

• Forward Guidance:

  • Central banks indicate future interest rates to guide long-term investments.

  • Effectiveness depends on the credibility of the central bank.

Challenges in Monetary Policy

• If short-term rates have minimal impact on long-term rates, monetary policy’s transmission mechanism weakens.

• Other considerations include:

  • The impact of fixed-rate mortgages on consumer behavior.

  • Changes in bank rate impacting other consumer and firm borrowing rates.

Summary of Monetary Policy Dynamics

• Monetary policy manages short-term interest rates:

  • Either sets money supply allowing demand to control equilibrium,

  • Or sets interest rates leading money supply adjustments.

• Long-term interest rates are a reflection of average short-term rates plus risk allowances.

• Influences aggregate demand, affecting consumption and investment.

Current Interest Rate Trends

• Short-term rates fell to 4.5% in the UK by early 2023, with implications for borrowing.

• Long-term rates have been rising despite cuts in short-term rates.

  • Factors influencing this include inflation expectations.

Yield Curve and Investment Demand

• Yield Curve:

  • Displays government borrowing rates across time.|

  • Typically upward sloping; inversely relates to economic health.

• Investment Demand Dynamics:

  • Inversely related to interest rates—higher rates restrict viable investment projects.

  • Demand shifts influenced by expected output and capital good costs.

Important Questions for Further Study

• Modeling the demand for money and investment demand.

• Understanding the role of interest rates in monetary policy and aggregate demand.

• Importance of medium/long-term debt yields as benchmark rates in the economy.