MONEY AND THE INTEREST RATE DETERMINATION OF. Dongpeng Liu Department of Economics Nanjing University

Transcription

1 MONEY AND THE DETERMINATION OF INTEREST RATE Dongpeng Liu Department of Economics Nanjing University

2 ROADMAP INCOME EXPENDITURE LIQUIDITY PREFERENCE IS CURVE LM CURVE SHORT-RUN IS-LM MODEL AGGREGATE DEMAND AGGREGATE SUPPLY INTERMEDIATE-RUN AS-AD MODEL SOLOW MODEL LONG-RUN w/ CAPITAL ACCUMULATION LONG-RUN AS-AD MODEL LONG-RUN w/o CAPITAL ACCUMULATION LABOR MARKET PHILLIPS CURVE MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 2

3 MONEY Money is an asset that can be easily used for transactions Functions of money Medium of exchange: Money is what we use to buy goods and services. The ease with which an asset can be converted in to the medium of exchange and used to buy goods and services is called the asset s liquidity. Store of value: Money is a way to transfer purchasing power from the present to the future. Unit of account: Money provides the terms in which prices are quoted and debts are recorded. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 3

4 TYPE OF MONEY Money that has no intrinsic value is called fiat money because it is established as money by government decree, or fiat. e.g., RMB, US dollars, Japanese yen, Euro etc. If not widely accepted, fiat money bills are just pieces of paper Most societies in the past have used a commodity with some intrinsic value for money, which is called commodity money. e.g., gold, silver, copper. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 4

5 THE DEVELOPMENT OF FIAT MONEY 1. People carry around bags of gold When a purchase is made, the buyer measures out the appropriate amount of gold If the seller is convinced that the weight and purity of the gold are right, the buyer and seller make the exchange High transaction cost (Why?) 2. The government gets involved in the monetary system to help reduce transaction costs The government can mint gold coins of known purity and weight Values of gold coins are widely recognized Lower transaction costs MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 5

6 THE DEVELOPMENT OF FIAT MONEY 3. Government accepts gold from the public in exchange for gold certificates If people believe the government s promise to redeem paper bill for gold, the bills are as valuable as the gold Bills are lighter than gold and easier to use. (Even lower transaction costs) No one carries gold around at all. Gold-backed government bills become the monetary standard. 4. Gold backing becomes irrelevant No one bothers to redeem the bills for gold No one cares if the option is abandoned as long as paper bills are widely accepted for exchange. Commodity money system evolves into fiat money system. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 6

7 HOW THE QUANTITY OF MONEY IS MEASURED Different countries use different measures M0: Currency M1: M0 + checkable deposits M2: M1 + saving deposits + time deposits Which of the following is a part of money balance? Balance in your debit card Credit card balance MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 7

8 MONEY vs. BONDS For simplicity, assume there are two types of financial assets Money Bonds Money can be used for transactions, but we do not receive interest payment by holding money. Bonds can not be used to buy goods and services, but we can receive interest payment from bonds. In reality, there are more than 1 kinds of bonds and different interest rates due to bonds different liquidities and levels of risk. For simplicity, we assume there is only 1 type of bonds and 1 interest rate. Interest rate (i) is the cost of holding 1 unit of money. People need to consider the tradeoff between convenience and returns MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 8

9 MONEY DEMAND: LIQUIDITY PREFERENCE THEORY Money demand depends on Amount of transactions: The more money needed for transactions, the more money is held. Interest rate: Higher interest rate Higher cost of holding money Lower money demand M = PYL(i) or M P = YL(i) P: general price level Y: real GDP PY: total amount of transactions M/P: real money demand and real money balance L(i): a decreasing function of interest rate MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 9

10 MONEY DEMAND CURVE MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 10

11 MONEY DEMAND CURVE Real money balance is on the horizontal axis Interest rate is on the vertical axis Money demand curve is downward sloping As interest rate changes, quantity of real money demanded moves along the money demand curve For any given interest rate, an increase in Y will lead to an increase in real money demand, causing the money demand curve to shift to the right MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 11

12 MONEY SUPPLY CURVE (Real) money supply is determined by the central bank. (Money supply is exogenous) Money supply curve is a vertical line. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 12

13 HOW MONEY SUPPLY IS CONTROLLED The primary way in which the central bank controls the supply of money is through open market operations Open market operations: The purchase and sale of government bonds by the central bank If central bank purchases bonds in the bonds market, then the sellers of bonds (the public) will receive money and money supply increases. This is called expansionary open market operation. If central bank sells bonds in the bonds market, then the buyers of bonds (the public) will pay with money and money supply decreases. This is called contractionary open market operation. MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 13

14 EQUILIBRIUM IN THE MONEY MARKET AND THE DETERMINATION OF EQUILIBRIUM INTEREST RATE If at a certain interest rate, (real) money demand equals (real) money supply, the money market is in equilibrium and the interest rate is the equilibrium interest rate We can figure out the equilibrium interest rate by finding the intersect of the money demand curve and money supply curve If there is an increase in money supply, there will be excess supply of money Interest rate drops Equilibrium in the money market is restored Controlling money supply and controlling interest rate are the two sides of the same coin MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 14

15 EQUILIBRIUM IN THE MONEY MARKET AND THE DETERMINATION OF EQUILIBRIUM INTEREST RATE MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 15

16 SUMMARY Money Money demand: liquidity preference theory Money supply and open market operations Money market equilibrium and the determination of equilibrium interest rate MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 16