**Unformatted text preview: **Chapter 12: Money Banking Prices, and Monetary Policy
A key part of the model is that consumers and firms make choices about their usage of credit
cards versus cash, and this is important for determining the demand for money.
the neutrality of money, under which a one-time change in the money supply has no real
consequences for the economy.
Monetary aggregate is simply the sum of a number of different assets for the U.S. economy The quantity of M0 is called outside money, as it is the quantity of money outside of the banking
y and Business Cycles
system d. A nominal bond
an asset that
sellsisforM1
oneplus
unitsavings
of moneydeposits,
(e.g., onesmall-denomination savings deposits, and retail
Theis quantity
of M2
e United States) inmoney
the current
period
and
pays
off
1
+
R
units
of
money
market mutual funds
e period. Therefore, R is the rate of return on a bond in units of money,
nal interest rate. Nominal bonds can be issued by the government, by
ACycles
Monetary
Intertemporal
Money
and Business
or by firms,
and all
bonds bear the
same nominal Model
interest rate, as we are
at no one defaults on their debts.
period.
nominal
bond
is an
that
for
one unit
of money
(e.g.,essentially
one
money
is
easily
recognizable,
there
are
no information problems associated
haptersA9–11,
theBecause
real rate
of asset
interest,
r,sells
is the
rate
of interest
in terms
n the
in
the
current
period
and
pays
off
1
+
R
units
of
money
he
realUnited
interestStates)
rate
is
the
real
rate
of
return
that
someone
receives
when
with the use of money in exchange
uture period.
Therefore,
R is period
the ratetoofthe
return
a bondThe
in real
unitsinterest
of money,
ominal
bond from
the current
futureonperiod.
nominal interest
rate.
Nominal
bonds
canand
be the
issued
by therate
government,
by
determined
from the
nominal
interest
rate,
inflation
i,
which
Real and Nominal Interest Rates and the Fisher Relation
mers,
or by firms, and all bonds bear the same nominal interest rate, as we are
y
ng that no one defaults on theirœ debts.
P - Pprimary assets, money and nominal bonds, and later we will introduce banks,
There
are
two
in Chapters 9–11,
the real
of .interest, r, is the rate of interest
in terms
i =rate
(12-1)
P rateother
s. The real interest
rate ishave
the real
of return
that
someone
receives when
which
some
assets
and
liabilities.
nflation
ratebond
is thefrom
rate of
the price
level
fromperiod.
the current
period
a nominal
theincrease
currentin
period
to the
future
The real
interest
e
period.
Then,
the
real
interest
rate
is
determined
by
the
Fisher
relation,
n be determined from
the
nominal
interest
rate,
and
the
inflation
rate
i,
which
A nominal bond is an asset that sells for one unit
of money in the current period and pays off
Irving
ed
by Fisher, which is
1 + R units of money in the future period
1 +PœR- P
1 + r =i =
. .
(12-2)
(12-1)
1 +return
iP
R is the rate of
on a bond in units of money, or the nominal interest rate
ethe
Fisher
relation,
thatof1increase
+ R is the
return
terms
of money
in the
inflation
rate isrecall
the rate
in the
priceinlevel
from
the current
period
d fromperiod.
givingThen,
up The
one
of
money
in
the
current
period
to
buy
a
nomuture
theunit
real
interest
rate
is
determined
by
the
Fisher
relation,
real interest rate is the real rate of
return that someone receives when holding a nominal
nafter
realIrving
terms,Fisher,
someone
acquiring
a nominal bond gives up 1P goods in the
which
is
bond from the current period to the future period.
od and receives a payoff of 1+R
+ the
R future period. Therefore, from
Pœ goods1in
r = nominal
. bond, in real terms, is
(12-2)
2-1), the gross rate of return 1on+ the
i –P/P)
inflation rate i: i1 =+ (P’
1+R
1 +1 R+ R 1
R return in terms of money in the
œ
ve the Fisher relation, recall
that
is +the
1 + r = P1 = Pœ =
,
period from givingFisher
up onerelation,
unit of money
in
current
period
to buy
a nom1 + i the
named
after
Irving
Fisher,
which
is: 1 + R = (1 + R / 1 + i)
P
P
nd. In real terms, someone acquiring a nominal bond gives up 1P goods in the
us the Fisher relation, Equation1+R
(12-2).
in theon
future
Therefore,
from
period and receives a payoff
ofrate
œ goods
gross
of return
theperiod.
nominal
bond
Pnominal
positive nominal The
interest
rate on
bonds—that
is,
R 7 0—the
ratein real terms
n (12-1), the gross rate of return on the nominal bond, in real terms, is
nominal bonds exceeds the rate of return on money. The nominal interest
1+R rate on money can be
is R>0 the
rate
ey is zero, and the real interest
determined
just
as of return on nominal bonds exceeds the rate of
1 + R 1 + R that
Pœ
1
+
r
=
, bond above. That is,
= with
=
ned the real interest rate associated
Pœ the nominal
1
return
on
money
1+i
P
eal rate of interest on money, then
as inP Equation (12-2), we have
gives us the Fisher relation, Equation
1
1 + 0 (12-2).
m
ven a positive nominal
interest
bonds—that is, R 7 0—the rate
= nominal
,
1 + r = rate on
1
+
i
1
i
n on nominal bonds exceeds the rate of+return
onifmoney.
Thereal
nominal
interest
rm is the
interest
on money and so if R>0 then rm<r, or the real
m
7
0 then
6 and
r, orthe
thereal
realinterest
rateononmoney
moneycan
is less
than the real
money
is rzero,
rate
be determined
justrate
as on the nominal bond.
interest
rateinterest
on money
is less
that
the
real
interest
on the nominal
bond. Inrate
ourassociated
monetarywith
intertemporal
model,
needThat
to is,
rmined
the real interest
the nominal
bondwe
above.
people
to hold
money then
if theyascan
receive a higher
of return
the
real are
ratewilling
of interest
on money,
in Equation
(12-2),rate
we have
native asset, nominal bonds, when the nominal interest rate is positive.
1
1+0
her relation can be rewritten
each
=
, side of Equation (12-2)
1 + rmby= multiplying
1+i
1+i
rearranging to get
if R 7 0 then rm 6 r, or the real interest rate on money is less than the real
r = R - i - ir.
rate on the nominal bond. In our monetary intertemporal model, we need to Rearranging you get : r = R - i - ir.
We can say that, for small inflation rates and interest rates, r ≈ R - i, that is, the real interest rate
is approximately equal to the nominal interest rate minus the inflation rate.
Banks and Alternative Means of Payment
For this task—building our monetary intertemporal model—the money stock corresponds to the
most narrow definition of money, outside money.
we want money not because it contributes directly to our happiness, but because it allows us to
acquire the goods and services that ultimately make us happy. Part V It will be useful to start our analysis by thinking of credit cards as the only alternative to currency
in transactions, and then show how we can generalize our thinking to include debit cards and
checks.
Money
and Business Cycles Monetary theorists would say that there is a lack of memory or recordkeeping on individuals in
recognizes government-supplied currency and Visa/Mastercard but
e supply curve is upward-sloping as the profitability of extending credit balances increases as q increases, so banks
few people know me or my creditworthiness.
crease quantity supplied.
q = Price of Credit Card Services gure 12.2 The Supplythe
Curve
for Credit
Card Services
credit
system.
Everyone (0,0) here exists a supply curve for credit card
services Xs(q) that denotes the quantity of
X s (q) credit card service
supplied given each price q.
assume that when an economic agent buys
some goods with a credit card, the economic
agent acquires a debt with the bank that is paid
off, at zero interest, at the end of the current
period X = Real Quantity of Credit Card Services in the
Market
fordoCredit
Card
Services,
and
Demand for Money
(or lend)Equilibrium
from one period
to the
next, they
so on the
credit
market at
the the
market
nominal interest rate R, with the borrowing and lending taking place at the beginning
of the period.
Y - Xd(q), which is the quantity of goods purchased with currency where Xd(q) is the demand for
creditincard
Equilibrium
theservices
Market for Credit Card Services, and the Demand
for Money
Suppose
that an for
economic
agent
considers
buying
one more
unit ofofgoods with credit, and one
To determine
the demand
credit card
services,
we need
to consider
the behavior
consumers, firms, and government purchasing agents who are on the demand side of
the goods market. Given that all of these economic agents want to collectively purchase
Y units of goods, their decision relates to the quantity of goods they wish to purchase
with credit cards, denoted by Xd (q) (the demand for credit card services) relative to
the remainder, Y - Xd (q), which is the quantity of goods purchased with currency. We
need to determine what Xd (q) looks like and then, given the supply curve for credit purchase all goods with a credit card. However, if
P(1 + R) 6 P(1 + q), (12-5) 6 q, then marginal benefit is less than marginal cost, and the economic agent will
hase all goods with currency. If R = q, then the agent is indifferent between using
ency and a credit card. This implies that the demand curve for credit card services
less12.3.
unitThe
of goods
with
currency.
depicted in Figure
demand
curve
is perfectly elastic at q = R. The he marginal benefit is P(1 + R) units of money at the beginning of the future period q = Price of Credit Card Services gure 12.3 Equilibrium
in the
Market formust
Creditgive
Card Services
the
consumer
up P(1 + q) units of money at the end of the
he demand curve for credit balances is horizontal at the price q = R, the equilibrium price of credit card services is
the
credit
debt and to pay the bank for its credit card services
= R and the equilibrium
quantity
is X ∗card
. X s (q) period in order to pay off If : P(1 + R) 7 P(1 + q), or R > q, then marginal
benefit is greater than marginal cost, and the
economic agent will purchase all goods with a
credit card
If: P(1 + R) 6 P(1 + q), or R 6 q, then marginal
benefit is less than marginal cost, and the
economic agent will purchase all goods with
currency. X d (q)
R R = q, consumer is indifferent Part V Money and Business Cycles
(0,0) X* Y X = Real Quantity of Credit Card Services gure 12.4 The Effect of an Increase in the Nominal Interest Rate on the Market for Credit Card Services q = Price of Credit Card Services n increase in the nominal interest rate from R1 to R2 shifts the demand curve for credit balances up from to X1d to X2d .
he equilibrium price of credit card balances increases from R1 to R2 and the equilibrium quantity increases from to X1∗
IF interest rate rises:
X2∗ . Equilibrium the price of credit card services
rises, and the quantity of credit case services
rises X s (q) equilibrium quantity of credit card services
rises when the nominal interest rate rises. R2 X 2d R1 X 1d (0,0) X1* X2* nominal quantity of currency that consumers,
firms, and the government want to hold to
make transactions is Md = P[Y - X∗(R)], or Md
= PL(Y, R), where the function L is increasing
in real income, Y, and decreasing in the
nominal interest rate, R.
Y Thus, the use of debit cards and checks must
rise with the nominal interest rate, as a higher
nominal interest rate implies a lower cost of using debit cards and checks relative to currency.
X = Real Quantity of Credit Card Services equilibrium price for credit card services is therefore R, and the equilibrium quantity
of credit card services is X∗ in the figure.
In Figure 12.4, consider what happens if the nominal interest rate rises from R1
to R2 . In equilibrium the price of credit card services rises, and the quantity of credit
card services rises from X1∗ to X2∗ . We can then write the equilibrium quantity of credit
card services as X∗ (R), which is an increasing function of the nominal interest rate R, to Md Money demand falls as the nominal interest rate rises, because a higher nominal interest rate
increases the opportunity cost of holding cash, and so consumers and firms are more inclined to
use alternative means of payment such as credit cards and debit cards.
assuming
theinreal
interest
rate and
theNominal
inflation
rate
are small)
Figure 12.6 The Effect
of an Increase
Current
Real Income
on the
Money
Demand
Curve implies that we can substitute r + i The current nominal money demand
curve shifts to the right with an increase in current real income
d Y. The curve shifts
foris aRdecrease
: Md in
= the
PL(Y,
r + i).
in the same way if there
real interest
rateand
r. when i is constant: M = PL(Y, r). If real income increases, for example from
Y1 to Y2, then in Figure 12.6 the money
demand curve shifts to the right from
PL(Y1, r) to PL(Y2, r). P
d M1 = PL(Y1, r)
d M2 = PL(Y2, r) Md In the current period, the government purchases G goods and pays the nominal interest and
principal on the government debt outstanding from the last period, (1 + R-)B-, where B- is the
quantity of one-period nominal bonds issued by the government in the previous period,
The government budget constraint in the current period is, therefore, given by: PG+(1+R-)B=PT+B+M-Mwith the left-hand side denoting total government outlays during the period, and the right-hand
side denoting total government receipts
right-hand side, PT denotes nominal taxes, B denotes government bonds issued in the current
period, M - M-, is the change in the nominal money supply, where M is the total quantity of
money outstanding in the current period, and M- is the previous period’s money supply
Competitive Equilibrium- The Complete Monetary Intertemporal Model
the market for current goods, the market for current labor, and the money market.
so the only important difference here from the model of Chapter 11 is the addition of the money
market.
the market for money, we will assume that the money supply Ms is determined exogenously by
the government as Ms = M the nominal quantity of money supplied equals the quantity of money
demanded, re 12.7 The Current Money Market in the Monetary Intertemporal Model figure shows the current nominal demand for money curve Md and the money supply curve Ms . The intersection of
e two curves determines the equilibrium price level, which is P∗ in the figure. P
M s M d = PL(Y, r + i ) the nominal quantity of money supplied equals
the quantity of money demanded M = PL(Y, r). P* Figure 12.8 The Complete Monetary Intertemporal Model
In the model, the equilibrium real interest rate r and equilibrium current aggregate output Y are determined in panel
(b). Then, the real interest rate determines the position of the labor supply curve in panel (a), where the equilibrium real
wage w and equilibrium employment N are determined. Finally,
M the equilibrium price level P is determined in the
money market in panel (c), given the equilibrium real interest rate r and equilibrium output
Y.s
d M ,M The complete Monetary Intertemporal
Model w
Nd
N s (r*) In the model, the equilibrium real interest rate r
and equilibrium
Labor Market
as
= M. Then for the money market to beCurrent
in equilibrium,
the nominal
quantity ofcurrent aggregate output Y are
determined in panel
money supplied
w* equals the quantity of money demanded, or
Ms M = PL(Y, r). (12-11) (b). Then, the real interest rate determines the
In Figure 12.7 we illustrate the workings of the money market,position
with theofnominal
the labor supply curve in panel (a),
we sawthe
previously.
money demand curve MdN*being upward-sloping and linear in P, aswhere
equilibrium
real wage w and
Here, we have added the money supply Ncurve, which is a vertical line at the quantity
equilibrium
employment N are determined.
M, because the (a)
money supply is exogenous. The intersection of the
nominal money
Finally,
the
equilibrium
price level P is
demand and nominal money supply curves determines the price level P. In the figure,
∗
determined in the money market in panel (c),
r
the equilibrium
price level is P .
Y d the money market into the real intertemporal
Next, integrating
of
given themodel
equilibrium
real interest rate r and
Chapter 11, we show in Figure 12.8Y show the endogenous variables
in
the
monetary
equilibrium output Y. intertemporal model are determined. In Figure 12.8(b), we depict equilibrium in the
Current
Goods
and the output supply curve
current goods market, where the output demand
curve
Y d Market
s
Y jointly determine the equilibrium real interest rate r∗ and the equilibrium quantity
r*
of aggregate output,
Y ∗ . Then, in Figure 12.8(a), given the equilibrium real interest rate
∗
r , which determines the position of the labor supply curve Ns (r∗ ), the labor demand
curve Nd and the labor supply curve Ns (r∗ ) jointly determine the equilibrium real wage
Y*
w∗ and the equilibrium quantity
of employment, N∗ . Then, in Figure 12.8(c), the equiY
∗
real interest rate r∗ determine the
librium quantity of output, Y , and the equilibrium
(b)
d
position of the money demand curve M . Then, the money demand curve and the
money supply
curve in Figure 12.8(c) determine the equilibrium price level P∗ .
P
Ms
M d = PL(Y*, r*) P* Current Money Market M
M d, M s
(c) A Level in Money Supply and Monetary Neutrality
a change in the level of the money supply of this sort is neutral, in that no real variables change,
but all nominal quantities change in proportion to the change in the money supply.
Because the nominal interest rate from the previous period, R-, and the quantity of bonds issued
by the government in the previous period, B-, were determined last period based on the
expectation that the quantity of money in circulation would be M1
3 possibilities:
1. The government could reduce current taxes T. The money supply increase, therefore, is reflected by a decrease in taxes on the household, which is the same as an increase
in transfers
2. The government could reduce the quantity of bonds, B, that it issues during the current
period.
3. open market operation, which in practice is car- ried out when the fiscal authority issues interest-bearing government debt, and then the monetary authority. open
market purchase is an exchange of money for interest-bearing debt by the
monetary authority, and an open market sale is the sale of interest-bearing debt
initially held by the monetary authority in exchange for money.
4. The government could temporarily increase the quantity of government spend- ing, G, in the current period. Seigniorage originally referred to the profit made by a
seigneur, or ruler, from issuing coinage, but it has come to take on a broader
meaning as the revenue earned by the government from issuing money.
revenue from the inflation tax
6 Part V Money and Business Cycles Figure 12.10 The Effects of a Level Increase in M—The Neutrality of Money A level increase in the money supply in the monetary intertemporal model from M1 to M2 has no effects on any real
variables, but the price level increases in proportion to the increase in the money supply. Money is neutral. That is, there a classical dichotomy: The w
Nd
N s (r 1)
Current Labor Market
w1 model solves for all the real variables
(output, employment, the real interest rate,
and the real wage) in the labor market and
the goods market in Figure 12.10, and the
price level is then determined, given real
output, in the money market.
A level increase in the money supply in the
monetary intertemporal model from M1 to
M2 has no effects on any real variables, but
the price level increases in proportion to
the increase in the money supply. Money is
neutral. N1
N
(a) r
Yd
Ys
Current Goods Market
r1 Y1 in proportion to M, so that M = L(Y, r)
remains unchanged. That is, if M increases
by PM Y
(b)
P s M1 s M2 M d = PL(Y1, r 1)
P2 Current Money Market P1 M1 M2
M d, M s (c) in equilibrium (money supply equals
money demand) and because Y and r are
unaffected by the increase in M, P must
increase 10%, then P increases by 10%, so that the
real money supply P is unaffected 58 Part V Money and Business Cycles Shifts in Money Demand
factor that affects either the demand or supply of credit card services will bring about a shift in
the demand for money Figure...

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