Chapter 12.pdf - Chapter 12 Money Banking Prices and...

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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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