L3-4: Money Demand, Interest Rates, and Monetary Policy Transmission

Money Demand, Interest Rates and Monetary Policy Transmission

• Developed by Sinchan Mitra

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.

Conceptual Framework:

• Understanding the basics of what we're dealing with.

• Two primary assets:

• Money:

  • What it is and why it's important.

  • Definition: Liquid asset used as a medium of exchange.

    • Liquidity means it can be easily used for transactions.

    • Medium of Exchange: It's accepted as payment.

  • Example: Cash in hand or money in a checking account.

    • This is readily available for spending.

• Bonds:

  • Definition: Interest-bearing asset that provides a return but is not used directly for transactions.

    • Interest-bearing: You earn money over time.

    • Not for direct transactions: You can't buy groceries with a bond.

  • Example: Government bonds or corporate bonds.

    • These are investments that pay interest.

Reasons for Holding Money:

• Why do people and businesses keep money instead of investing?

• Liquidity for transactions without transaction costs.

  • Explanation: Money allows you to quickly and easily make purchases without needing to convert other assets.

    • You don't have to sell a bond to buy something.

• Universally accepted as payment.

  • Explanation: Businesses and individuals widely accept money as a means of payment for goods and services.

    • Everyone takes cash or debit cards.

Reasons for Holding Bonds:

• Why invest in bonds?

• Financial returns through the interest rate.

  • Explanation: Bonds provide income in the form of interest payments over a specified period.

    • You earn interest over time.

Money Demand Determinants:

• What factors influence how much money people want to hold?

• Holding money depends on:

• Frequency of transactions.

  • Example: A business with frequent sales will need to hold more money than one with infrequent sales.

    • More sales mean more cash needed.

• Institutional and technological factors.

  • Explanation: Factors like the availability of ATMs and online banking influence how much money people hold.

    • Easier access to cash means less cash on hand needed.

Nominal GDP as a Metric:

• How does the economy's size relate to money demand?

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

  • Explanation: The higher the nominal GDP, the more money is needed for transactions.

    • A bigger economy needs more money moving around.

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

  • Explanation: After adjusting for inflation, real money demand is related to the actual quantity of goods and services produced.

    • Real GDP is the economy's output adjusted for price changes.

Interest Rate Effects:

• How do interest rates affect people's desire to hold money?

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

  • Explanation: When interest rates are high, people prefer to hold bonds to earn more interest, reducing the amount of money they want to hold.

    • High rates make bonds more attractive.

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

  • Explanation: As people earn more, they demand more money for transactions, but higher interest rates make them want to hold less money.

    • More income means more spending, but high rates encourage saving.

Money Market Equilibrium

• Where money supply meets money demand.

• Role of Central Bank:

  • How central banks influence the money supply.

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

    • Definition: High powered money refers to the total currency in circulation plus commercial banks' reserves held at the central bank.

      • This is the base level of money in the economy.

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

    • Explanation: When prices don't change quickly, the central bank can influence the actual amount of money available.

      • Short-term price stickiness allows control.

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

    • Explanation: When prices can adjust freely, they can offset the central bank's control over the money supply.

      • Prices adjust to counteract central bank actions.

• Central Bank’s Monetary Policy Approach:

  • How central banks manage the money supply.

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

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

      • Easier to control rates than quantity.

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

    • Adjusting base affects overall supply.

• Reasons for Interest Rate Focus:

  • Why focus on interest rates?

  • Modern central banks favor interest rates due to:

  • Uncertainty about money multipliers.

    • Explanation: The money multiplier is the ratio of the money supply to the monetary base. If this is unpredictable, controlling interest rates is more effective.

      • Multiplier instability makes quantity control hard.

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

    • Explanation: With so many different ways to store value (like stocks or real estate), the demand for money can be unstable.

      • Many investment options complicate money demand.

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

    • Rates offer more precise control.

• Effects of Monetary Policy on the Economy:

  • How monetary policy impacts the economy.

  • In a Closed Economy:

    • No international trade or finance.

    • Monetary policy influences aggregate demand through interest rate adjustments.

      • Rates affect overall spending.

• Relationship between interest rates and consumption:

  • How rates affect consumer spending.

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

    • Explanation: Lower rates make future earnings more valuable today, increasing the attractiveness of investments.

      • Low rates boost company values.

  • This wealth effect increases consumer spending.

    • Explanation: As people feel wealthier due to higher asset values, they tend to spend more.

      • Feeling richer leads to more spending.

• Expansionary Monetary Policy Impact:

  • What happens when the central bank lowers rates?

  • Expands availability of credit and lowers borrowing costs.

    • Easier and cheaper to borrow money.

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

    • Future rate expectations guide investment.

  • Forward Guidance:

    • Central bank communication about future policy.

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

      • Signals help investors plan.

    • Effectiveness depends on the credibility of the central bank.

      • Trust is crucial.

      • Lehman's Terms: If the central bank isn't trusted, their words don't mean much.

        • No one believes an untrustworthy bank.

• Challenges in Monetary Policy:

  • What makes monetary policy difficult?

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

    • Short rates must influence long rates.

  • Other considerations include:

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

      • Mortgages affect spending and saving.

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

      • Bank rates influence borrowing costs.

• Summary of Monetary Policy Dynamics

  • How it all works together.

  • Monetary policy manages short-term interest rates:

    • Controlling short-term rates is key.

    • Either sets money supply allowing demand to control equilibrium,

      • Supply adjusts to demand.

    • Or sets interest rates leading money supply adjustments.

      • Rates drive supply changes.

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

    • Long rates depend on short rates and risk.

  • Influences aggregate demand, affecting consumption and investment.

    • Policy impacts overall spending.

• Current Interest Rate Trends:

  • What's happening now?

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

    • Lower UK rates affect borrowing.

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

    • Conflicting trends in rates.

  • Factors influencing this include inflation expectations.

    • Inflation drives rate changes.

• Yield Curve and Investment Demand:

  • How the yield curve affects investment.

  • Yield Curve:

    • Displays government borrowing rates across time.

    • Displays government borrowing rates across time.

      • Shows rates for different loan periods.

    • Typically upward sloping; inversely relates to economic health.

      • Shape indicates economic outlook.

• Investment Demand Dynamics:

  • Factors affecting investment.

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

    • High rates reduce investment.

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

    • Expectations and costs drive demand.

• Important Questions for Further Study:

  • What to explore next.

  • Modeling the demand for money and investment demand.

    • Understand demand drivers.

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

    • How rates shape policy and spending.

  • Importance of