Supply and Demand in the market for the money

Then the income price level and expected inflation

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Unformatted text preview: . Because these effects are dominant, the interest rate eventually rises above its initial level to i2. In the short run, lower interest rates result from increased money growth, but eventually they end up climbing above the initial level. Supply and Demand in the Market for Money: The Liquidity Preference Framework W-39 Panel (c) has the expected-inflation effect dominating as well as operating rapidly because people quickly raise their expectation of inflation when the rate of money growth increases. The expected-inflation effect begins immediately to overpower the liquidity effect, and the interest rate immediately starts to climb. Over time, as the income and price-level effects start to take hold, the interest rate rises even higher, and the eventual outcome is an interest rate that is substantially above the initial interest rate. The result shows clearly that increasing money supply growth is not the answer to reducing interest rates but rather that money growth should be reduced in order to lower interest rates! An important issue for economic policymakers is which of these three scenarios is closest to reality. If a decline in interest rates is desired, then an increase in money supply growth is called for when the liquidity effect dominates the other effects, as in panel (a). A decrease in money growth is appropriate if the other effects dominate the liquidity effect and expectations of inflation adjust rapidly, as in panel (c). If the other effects dominate the liquidity effect but expectations of inflation adjust only slowly, as in panel (b), then whether you want to increase or decrease money growth depends on whether you care more about what happens in the short run or the long run. Which scenario is supported by the evidence? The relationship of interest rates and money growth from 1950 to 2004 is plotted in Figure 6. When the rate of money supply growth began to climb in the mid-1960s, interest rates rose, indicating that the liquidity effect was dominated by the price-level, income, and expected-inflation effects. By the 1970s, interest rates reached levels unprecedented in the period after World War II, as did the rate of money supply growth. Money Growth Rate (% annual rate) Interest Rate (%) 22 14 20 Money Growth Rate (M2) 18 12 16 10 14 8 12 10 6 8 4 6 4 2 Interest Rate 2 0 0 — 2 — 2 — 4 — 6 1950 Figure 6 — 4 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2004 Sources: Federal Reserve Bulletin, various years. Tables 1.1 line 6 and http://www.federalreserve.gov/releases/H15/data.htm W-40 Appendix 4 to Chapter 4 The scenario depicted in panel (a) of Figure 5 seems doubtful, and the case for lowering interest rates by raising the rate of money growth is much weakened. You should not find this too surprising. The rise in the rate of money supply growth in the 1960s and 1970s is matched by a large rise in expected inflation, which would lead us to predict that the expected-inflation effect would be dominant. It is the most plausible explanation for why interest rates rose in the face of higher money growth. However, Figure 6 does not really tell us which one of the two scenarios, panel (b) or panel (c) of Figure 5, is more accurate. It depends critically on how fast people’s expectations about inflation adjust. However, recent research using more sophisticated methods than just looking at a graph like Figure 6 does indicate that increased money growth temporarily lowers short-term interest rates.4 4See Lawrence J. Christiano and Martin Eichenbaum, “Identification and the Liquidity Effect of a Monetary Policy Shock,” in Business Cycles, Growth, and Political Economy, ed. Alex Cukierman, Zvi Hercowitz, and Leonardo Leiderman (Cambridge, Mass.: MIT Press, 1992), pp. 335–370; Eric M. Leeper and David B. Gordon, “In Search of the Liquidity Effect,” Journal of Monetary Economics 29 (1992): 341–370; Steven Strongin, “The Identification of Monetary Policy Disturbances: Explaining the Liquidity Puzzle,” Journal of Monetary Economics 35 (1995): 463–497; and Adrian Pagan and John C. Robertson, “Resolving the Liquidity Effect,” Federal Reserve Bank of St. Louis Review 77 (May–June 1995): 33–54....
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