Week 5. Remainder of chapter 9: the complete real model Chapter 10: money Copyright 2008 Pearson Addison-Wesley. All rights reserved.

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1 Week 5 Remainder of chapter 9: the complete real model Chapter 10: money 10-1

2 A Decrease in the Current Capital Stock This could arise due to a war or natural disaster. Output may rise or fall, depending on how large the output demand effect is relative to the output supply effect. The real interest rate rises, the real wage falls, employment may rise or fall. 5-2

3 Figure 9.20 The Equilibrium Effects of a Decrease in the Current Capital Stock 5-3

4 Current Total Factor Productivity Increases Real interest rate falls, consumption and investment rise, employment rises, real wage rises. Productivity shocks are a potential explanation for business cycles see Chapter

5 Figure 9.21 The Equilibrium Effects of an Increase in Current Total Factor Productivity 5-5

6 Total Factor Productivity Expected to Increase in Future Output demand curve shifts right. Real interest rate rises, investment increases, consumption may rise or fall, employment rises, real wage falls, output rises. Important in explaining investment boom in the 1990s. 5-6

7 Figure 9.22 The Equilibrium Effects of an Increase in Future Total Factor Productivity 5-7

8 Figure 9.25 S and P 500 Stock Price Index,

9 Figure 9.24 Investment as a Percentage of GDP,

10 Chapter 10 Topics What is money? Real and nominal interest rates Monetary Intertemporal Model to derive money demand Neutrality of money 10-10

11 What is Money? Medium of exchange Unit of account Store of value 10-11

12 Table 10.1 Monetary Aggregates, July 2006 (in $Billions) 10-12

13 Equation 10.2 Fisher relation: With inflation rate: 10-13

14 Equation 10.3 Approximate Fisher relation: The real interest rate is the nominal interest rate minus the rate of inflation 10-14

15 Figure 10.1 Real and Nominal Interest Rates,

16 Monetary Intertemporal Model Type of cash-in-advance model. Representative consumer, representative firm, and government. Consumers and firms require cash on hand to purchase goods, or can use the services of banks to carry out transactions

17 Monetary Intertemporal Model Consider one period as being one day The consumer needs either money or banking services (a credit card for example) to buy consumption goods, he needs cash in advance Therefore we have a cash-in-advance constraint The consumer can invest part of its income in bonds with interest rate R 10-17

18 Monetary Intertemporal Model The consumer has to choose how much money to hold The more banking services he uses, the less money he needs to hold and the more money he can invest in bonds with a rate of return of R, but also the more he has to pay for banking services So, when choosing the amount of money to hold, the tradeoff is between the return on investing in bonds and the cost of banking services 10-18

19 Equation 10.4 Consumer s currency withdrawal at the beginning of the day: 10-19

20 Equation 10.5 Consumer s cash-in-advance constraint: PC = WD + C PX 10-20

21 Equation 10.6 Money balances held by the consumer at the bank at the end of the day: 10-21

22 Figure 10.2 The Cost of Banking Services 10-22

23 Equation 10.7 The marginal benefit for the consumer of using more banking services: 10-23

24 Equation 10.8 Consumer s end-of-day money holdings: 10-24

25 Equation 10.9 Marginal cost for the consumer of using more banking services: 10-25

26 Equation Determine the optimal choice of X: 10-26

27 Equation Optimal choice of X, simplified: 10-27

28 Figure 10.3 The Consumer s Optimal Choice of Banking Services 10-28

29 Figure 10.4 The Effect of an Increase in R on the Consumer s Optimal Choice of Banking Services 10-29

30 Equation The optimal choice of X is an increasing function of the nominal interest rate, R: 10-30

31 Equation Firm s currency withdrawal at the beginning of the day: 10-31

32 Equation Firms cash-in-advance constraint: 10-32

33 Equation Direct deposit made by the firm to the consumer s bank: A = PY PI PH ( X ) ( ) f + B f 1+ R B f 10-33

34 Equation Simplified direct deposit to the consumer: A = PY PX PH ( ) f X f 10-34

35 Equation Government budget constraint: 10-35

36 Equation Income-Expenditure identity: 10-36

37 Equation Substitute using cash-in-advance constraints and government budget constraint: 10-37

38 Equation Credit market clears in previous period: 10-38

39 Equation Current credit market clears: 10-39

40 Equation Money market clears in previous period: 10-40

41 Equation In equilibrium, then: 10-41

42 Equation Rewrite given the choice of banking services by the consumer and the firm: When the interest rate rises, it becomes more attractive to pay using X (credit card). As a result the demand for money decreases When income rises, more money is needed to do transactions and therefore money demand rises 10-42

43 Equation Nominal money demand function: When the price level P is higher, you need also more money to do transactions, like with higher real income Y (There is an indirect effect through a higher inflation rate: it becomes less attractive to hold money relative to bonds, when the rate of return on bonds rises with the inflation) 10-43

44 Equation Nominal money demand using the Fisher relation: 10-44

45 Equation Nominal money demand assuming the inflation rate equals zero (harmless assumption for our purposes here): 10-45

46 Equation Money supply equals money demand: 10-46

47 Figure 10.5 The Nominal Money Demand Curve in the Monetary Intertemporal Model 10-47

48 Figure 10.6 The Effect of an Increase in Current Real Income on the Nominal Money Demand Curve 10-48

49 Figure 10.7 The Current Money Market in the Monetary Intertemporal Model 10-49

50 Figure 10.8 The Complete Monetary Intertemporal Model 10-50

51 Figure 10.9 A Level Increase in the Money Supply in the Current Period 10-51

52 Three Ways to Raise Money Supply Start from government budget constraint: An increase in G: finance government expenditures through seigniorage A decrease in taxes: a helicopter drop of money Buying government bonds: monetary financing of the debt. Hence the amount of bonds B to be issues to the public is less than 10-52

53 The Neutrality of Money In the monetary intertemporal model, a level increase in the money supply increases the price level and the nominal wage in proportion to the money supply increase, but has no effect on any real macroeconomic variable

54 Figure The Effects of a Level Increase in M The Neutrality of Money 10-54

55 Decrease in Total Factor Productivity If z decreases, this decreases money demand (Y increases and r falls), which causes the price level to rise

56 Figure Short-Run Analysis of a Temporary Decrease in Total Factor Productivity 10-56

57 Figure An Increase in the Cost of Banking Services 10-57

58 Figure The Effect of an Increase in the Cost of Banking Services on the Choice of Banking Services 10-58

59 Shift in the Demand for Money When Costs of Banking Decrease 10-59

60 Figure A Shift in the Output Demand Curve Output demand increases Output and the real interest rate rise Assuming that output effect dominates Money demand will increase As a result the price level falls unless money supply rises More demand for money and price level decreases??? Think of value of money as the inverse of the price level: the higher inflation, the lower the value of money 10-60

61 Figure A Shift in the Output Supply Curve Output supply increases Output increases and the interest rate decreases Money demand increases The price level will fall, unless the central bank changes the money supply 10-61

62 Monetary Policy Rules Money supply targeting. Nominal interest rate targeting. The Taylor rule