Interest Rates in the Short-Run - (Back to Top)

In the previous chapter, there were three effects that led to the downward slope of the aggregate
demand curve - the Pigou Wealth effect, the Keynes Interest Rate effect and the Mundell-
Fleming Exchange Rate effect. Of these three, the Keynes Interest Rate effect is by far the most
important (the Pigou effect is small because money holdings are a very small portion of
household wealth, and the Mundell-Fleming effect is small because net exports are a small
portion of GDP). This section expands on the Keynes Interest Rate effect by developing
Keynes's theory of liquidity preference.
theory of liquidity preference -
Keynes's theory that the interest rate adjusts to bring money supply and money demand
into balance .
The AD-AS model is a short-run model that
describes economic fluctuations around the long-run
trend. The theory of liquidity preference is a short-
run model of interest rate determination.

Money Supply

In the US economy, the money supply is determined

by the Fed. Recall that the Fed can either increase or
decrease the size of the money supply through open
market operations, changing reserve requirements,
or changing the discount rate. Since the money
supply is a policy variable determined by the Fed, it is drawn as a vertical line.

Money Demand

Recall that one of the reasons money has value is that money is the most liquid of all assets in the
economy. The liquidity of money comes from the fact that money IS the medium of exchange.
Because money is used to pay for goods and services, there is a demand in the economy for
people to hold cash. According to Keynes's theory of liquidity preference, the most important
determinant of money demand is the interest rate. When people hold money, they give up
interest income they could have earned had they deposited the money in a savings account or
purchased a government bond. Therefore, the interest rate is the opportunity cost of holding
money. The higher is the interest rate, the higher is the foregone interest income. For this reason,
the money demand curve has a negative slope.

NOTE: In the chapter "inflation: its causes and costs" you learned a different model of money
demand and supply. In that long-run model the only variable that affected money demand was
the price level, which was inversely related to the value of money. You should be careful to note
that the earlier model of money demand and supply and Keynes's theory of liquidity preference
are two different models. The earlier model is applicable in the long-run and the theory of
liquidity preference is applicable in the short-run.

In the money market, the equilibrium is found at the intersection of money demand and money
supply. This is the only interest rate (r*) where the quantity of money demanded EQUALS the
quantity of money supplied. At all other interest rates there will be either a shortage or surplus of
money in the economy. Shortages of money (when r < r*) will drive interest rates up and
surpluses of money (when r > r*) will drive interest rates down.
The Money Market and Aggregate Demand

The figure at right provides a complete description

of the Keynes Interest Rate effect, including the
theory of liquidity preference.

Suppose that the economy is originally at P1 and Y1

in the bottom figure. In the money market (top
figure), money demand at a fixed price level of P1 is
labeled as MD@P1. The interest rate is r1.

If the price level increases to P2, the money demand

curve shifts to the right (MD@P2). This increase in
money demand comes from the fact that people need
more money to buy goods and services when prices
are higher. The rightward shift in money demand
causes the equilibrium interest rate to rise to r2. In
the bottom figure, the higher equilibrium interest
rate causes the quantity of goods and services
demanded to fall to Y2 (Y2<Y1). Since the price
level rose and the quantity of goods and services
demanded fell, aggregate demand must have a
negative slope.

There are several reasons why the higher interest rate causes the quantity of goods and services
demanded to fall. First, higher interest rates will discourage some people from borrowing money
to build a new house - thus, residential investment falls. Second, higher interest rates will
discourage firms from issuing bonds or borrowing money to build new capital - thus, business
investment falls. Finally, higher interest rates encourage people to save more money. However,
higher savings comes at the cost of lower current
consumption. All three of these effects cause the
quantity of goods and services (C + I + G + NX) to
fall.

Monetary Policy - (Back to Top)

Suppose the Fed increases the size of the money
supply as shown in the top figure at right. This is
called an expansionary monetary policy.

Q: How does the Fed increase the money supply?

A: Three ways: the Fed could BUY bonds in an
open market operation; the Fed could reduce reserve
ratios; or the Fed could lower the Fed Discount
Rate.
Q: How does an increase in the money supply affect the AD curve?
A: In the short-run, the increase in the money supply is NOT offset by an increase in the price
level (recall that the classical dichotomy and monetary neutrality have been abandoned in this
short-run model). As the money supply increases, the interest rate falls. Lower interest rates
cause investment spending to rise, and also cause savings to fall. The fall in savings is
accompanied by a rise in consumption spending. These effects indicate that the quantity of goods
and services demanded has increased - even though the price level has NOT changed (prices are
fixed at P1). As a result, the aggregate demand curve must have shifted to the right.

This process will work in reverse as well. Suppose that the Fed wanted to REDUCE aggregate
demand in the economy (this is common when combating inflation). In this case, the Fed could
SELL bonds in an open market operation, INCREASE reserve ratios or INCREASE the Fed
discount rate. Each of these policy options will have the effect of decreasing the money supply
(shifting it left). A decreasing money supply causes interest rates to rise. As a result, the quantity
of goods and services demanded at all price levels falls, and the AD curve shifts to the left. This
is called restrictive monetary policy.

Money Supply or Interest Rate Targets?

As you have seen, it is equivalent in the money

market to think of changing the money supply or
changing interest rates - that is, for a fixed money
demand curve, the money supply determines the
interest rate, OR a targeted interest rate determines
the required size of the money supply. Since the
money supply is a difficult variable to measure
accurately, the Federal Open Market Committee
(FOMC) usually chooses to target interest rates.

Fiscal Policy - (Back to Top)

Fiscal policy involves changing the level of government spending or taxes in the economy.

Changes in Government Spending

Changes in government spending have a direct impact on the quantity of goods and services
demanded. Since total output equals C + I + G + NX, an increase in government spending shifts
aggregate demand to the right, and a decrease in government spending shifts aggregate demand
to the left.

Changes in Taxes

Changes in taxes affect the after-tax take home pay of households in the economy. Tax cuts
increase take home pay and tax increases reduce
take home pay. When taxes are cut, consumers save
some of their new income and the remainder is spent
on consumption. Therefore, tax cuts have the effect
of increasing the quantity of goods and services
demanded (AD shifts right) and tax increases have
the effect of decreasing the quantity of goods and
services demanded (AD shifts left).

In one sense, tax changes are more complicated than

changes in government spending. Whether a tax
change is perceived as permanent or temporary will
have a dramatic impact on the size of the shift in AD. Suppose that a tax cut is announced as
being a temporary tax cut.

Q: What is the impact of a temporary tax cut on AD?

A: A temporary tax cut provides only a small increase to a household's total financial resources,
so temporary tax changes will have a SMALL impact on aggregate demand.

Q: What is the impact of a permanent tax cut on AD?

A: A permanent tax cut increases take home pay this year and all years in the future. This
represents a much larger increase in a household's total financial resources than that afforded by
a temporary tax change. Permanent tax changes will have a substantial effect on aggregate
demand.

Whether the government changes its spending or changes taxes, there are two effects that
determine the overall size of a shift in AD. These effects are the multiplier effect and the
crowding out effect.

The Multiplier Effect

Suppose that the government permanently reduces taxes by $1million. This permanent tax cut
will have a substantial impact on AD, shifting it to the right. In the figure at right, this is depicted
by a shift from AD1 to AD2.

Now think about what households do with the extra $1million in income - they save some (say
25%), but they SPEND the rest ($750,000) on consumption (this is the cause of the initial shift in
AD). Suppose the $750,000 is spent on movie tickets.

Q: What becomes of this $750,000?

A: It goes either to pay for wages at movie theatres or to the theatre's profits. In any case, this
extra spending becomes somebody else's income.

Q: What do the employees and owners of movie theatres do with their $750,000 in new income?
A: They save some (again, say 25%) and spend the rest ($562,500) on consumption.

This process of spending and respending continues as money flows around the economy. In each
round, some of the new income gets saved and a smaller amount of income is spent on
consumption (the $562,500 in the second round was
less than the $750,000 initially spent). However,
after only two rounds, you can see that the increase
in consumption is LARGER than the size of the tax
cut ($1,312,500 > $1,000,000).

The multiplier effect is the additional shifts in

aggregate demand that result when expansionary
fiscal policy increases income and thereby increases
consumer spending. In the figure at right (above),
the multiplier effect is depicted by the fact that
subsequent spending, as income flows around the
economy, shifts aggregate demand further to the
right, from AD2 to AD3.

The Crowding Out Effect

The multiplier effect suggested that changes in

government spending or taxes will cause shifts in
AD that are larger than the original spending or tax
change. The crowding out effect suggests the
opposite - that changes in spending or taxes could
cause shifts in AD that are SMALLER than the original spending or tax change.

In the figure at right (bottom), a tax cut or spending increase has shifted aggregate demand to the
right (from AD1 to AD2). This increase in the quantity demanded for goods and services at ALL
prices causes an increase in the demand for money (from MD1 to MD2). In the money market
(top graph), the interest rate rises as a result of the increase in the demand for money.

Recall that rising interest rates will tend to reduce the quantity of goods and services demanded
at ALL price levels, partly because higher interest rates make borrowing money for investing in
new capital MORE costly. This reduction in the quantity of goods and services demanded shifts
aggregate demand back to the left (from AD2 to AD3).

The crowding out effect is the offset in aggregate demand that results when expansionary fiscal
policy raises the interest rate and thereby reduces investment spending. Crowding out implies
that the size of the shift in AD resulting from a spending or tax change may be SMALLER than
the size of the original change.

The overall effect of a spending or tax change will depend BOTH on the size of the multiplier
effect and the crowding out effect. If the multiplier effect is larger, the shift in AD will be larger
than the original change. If the crowding out effect is larger, the shift in AD will be smaller than
the original change.

The Debate Over Stabilization Policy - (Back to Top)

What is stabilization policy and why use it?

The figures above depict two short-run situations that call for stabilization policy - either AD is
insufficient (left figure) or AD is excessive (right figure). Stabilization policy refers to the use of
monetary and fiscal policy to reduce short-run economic fluctuations.

In particular, suppose the economy, because of consumer pessimism, has insufficient AD to

produce the "natural rate of output" (the natural rate of output, given at the long-run AS curve, is
Y0 in BOTH figures). In this case, AD = AD1, and the economy's level of output, Y1, is less than
the natural rate of output Y0. Recall that this situation is recessionary since low output is
associated with unemployment ABOVE the natural rate of unemployment. You have learned 3
possible stabilization policies: first, the Fed could expand the money supply, which has the effect
of shifting AD to the right (back to AD1); second, the government could reduce taxes (again, this
shifts AD back towards AD1); third, the government could increase government spending (also
shifting AD back towards AD1). In terms of the AD-AS model, stabilization policy refers to the
use of fiscal or monetary policy to push the economy back towards the natural rate of output.

Alternatively, a wave of consumer optimism may have pushed the economy beyond the natural
rate of output (this is the right figure, and AD = AD2). Output in the economy (Y1) exceeds the
natural rate of output, and unemployment is LOWER than the natural rate of unemployment.
This situation is inflationary, and economists will often describe the economy as "overheating"
when this occurs. There are still 3 appropriate stabilization policies in this situation (they're just
the reverse of the previous case): first, the Fed could shrink the money supply, which raises
interest rates and shifts AD to the left (towards AD0); second, the government could increase
taxes (again shifting AD towards AD0); third, the government could cut its spending on goods
and services (also shifting AD towards AD0).

The argument FOR the active use of stabilization policy is straightforward - BOTH recessions
and inflations are undesirable. If the government and the fed can actively manipulate AD to
reduce the size of short-run fluctuations, the costs of recessions and inflations can be avoided.

Why NOT use stabilization policies?

While the previous analysis may lead you to think that stabilization policies SHOULD be used,
there are solid arguments against using them. The argument most often cited is that both
monetary and fiscal policies work with a substantial lag. For monetary policy, realize that
households and firms plan their investment expenditures (whether on a new house or on plant
and equipment) in advance - therefore, a change in the interest rate may NOT change investment
spending immediately. Fiscal policy has a more complicated lag - any change in government
spending or taxation has to FIRST go through the congress, and SECOND be signed by the
President. This political process can take months or years.

The problem with using stabilization policies in the face of lags is that economic situations may
change between the implementation of the policy and its effect on the economy. It's very possible
that, by the time stabilization policy takes effect, policymakers don't want it anymore.
Additionally, the use of stabilization policy, because of the lags, requires accurate forecasting of
future economic conditions. As your textbook points out, economic forecasting is imprecise.

What are Automatic Stabilizers?

The makeup of the tax and spending system includes automatic stabilizers, or changes in
spending and taxes that react automatically to changes in economic conditions. Most taxes in the
economy are tied to the level of economic activity - income taxes, payroll taxes corporate taxes,
etc. As the economy falls into a recession, income, earnings and profits all fall together, and tax
collections fall as well, but this automatic tax cut IS a stabilization policy, and it works without a
lag. Government spending also has a stabilizing influence. When the economy falls into a
recession, welfare benefits and unemployment insurance increase (these BOTH increase
government spending). Again, this automatic increase in government spending IS a stabilization
policy. These automatic stabilizers also work in the face of inflation. With inflation, taxes
automatically rise (as incomes rise) and government spending falls (as unemployment insurance
and welfare benefits fall).

Because automatic stabilizers help to reduce the size of short-run economic fluctuations, many
economists oppose legislation that would force the government to balance its budget. When there
is a recession, taxes automatically fall and spending automatically rises, leading to a deficit. With
inflation, taxes automatically rise and spending automatically falls, leading to a surplus. This is
how the automatic stabilizers work. Strict balanced budget amendments would eliminate the
actions of the automatic stabilizers.

Chapter 21: The Demand for Money

Chapter 21 begins the last section of your textbook, which deals with monetary theory. Monetary
theory develops the link between money supply and other macroeconomic variables, including
the price level and output (GDP). In this chapter we begin with competing theories of money
demand and some empirical evidence about the behavior of money demand.
I. The Quantity Theory of Money
This theory, developed by the classical economists over 100 years ago, related the amount of
money in the economy to nominal income. Economist Irving Fisher is given credit for the
development of this theory. It begins with an identity known as the equation of exchange:
MV = PY
Where M is the quantity of money, P is the price level, and Y is aggregate output (and aggregate
income). V is velocity, which serves as the link between money and output. Velocity is the
number of times in a year that a dollar is used to purchased goods and services.
The equation of exchange is an identity because it must be true that the quantity of money, times
how many times it is used to buy goods equals the amount of goods times their price.
To move towards the quantity theory of money, Fisher makes two key assumptions:
1. Fisher viewed velocity as constant in the short run. This is because he felt that velocity is
affected by institutions and technology that change slowly over time.
2. Fisher, like all classical economists, believed that flexible wages and prices guaranteed
output, Y, to be at its full-employment level, so it was also constant in the short run.
Putting these two assumptions together lets look again at the equation of exchange:
MV = PY
If both V and Y are constant, then changes in M must cause changes in P to preserve the equality
between MV and PY. This is the quantity theory of money: a change in the money supply,
M, results in an equal percentage change in the price level P.
We can further modify this relationship by dividing both sides by V:
M = (1/V) x PY
Since V is constant we can replace (1/V) with some constant, k, and when the money market is
in equilibrium, Md = M. So our equation becomes
Md = k x PY
So under the quantity theory of money, money demand is a function of income and does not
depend on interest rates.
Is Velocity Constant?
A constant V is key to the quantity theory of money. For Fisher, the assumption was a leap of
faith since data on GDP and the money supply did not exist in 1911. However, looking at that
data in Figure 1, page 542, we see very clearly that velocity is not constant, even in the short run.
In particular, velocity drops significantly during recessions.
With the problems of the Great Depression, economists began to look for factors other than
income that influence money demand.
II. Keynes Liquidity Preference Theory
In 1936, economist John M. Keynes wrote a very famous and influential book, The General
Theory of Employment, Interest Rates, and Money. In this book he developed his theory of
money demand, known at the liquidity preference theory. His ideas formed the basis for the
liquidity preference framework discussed in chapter 5.
Keynes believed there were 3 motives to holding money:
• Transactions motive. Money is a medium of exchange, and people hold money to buy
stuff. So as income rises, people have more transactions and people will hold more
money
• Precautionary motive. People hold money for emergencies (cash for a tow truck,
savings for unexpected job loss). Since this also depends on the amount of transactions
people expect to make, money demand is again expected to rise with income.
• Speculative motive. Money is also a way for people to store wealth. Keynes assumed
that people stored wealth with either money or bonds. When interest rates are high, rate
would then be expected to fall and bond prices would be expected to rise. So bonds are
 more attractive than money when interest rates are high. When interest rates are low, they
then would be expected to rise in the future and thus bond prices would be expected to
fall. So money is more attractive than bonds when interest rates are low. So under the
speculative motive, money demand is negatively related to the interest rate. (We
have seen this already in chapter 5).
Keynes also modeled money demand as the demand for the REAL quantity of money (real
balances) or M/P. In other words, if prices double, you must hold twice the amount of M to buy
the same amount of stuff, but your real balances stay the same. So people chose a certain amount
of real balances based on the interest rate, and income:
M/P = f(i, Y)
The importance of interest rates in the Keynesian approach is the big difference between Keynes
and Fisher. With this difference also comes different implications about the behavior of velocity.
Consider the two equations:
MV = PY
M/P = f (i, Y)
so M = PY/V in the first equation. Substituting in the second equation:
Y/V = f(i, Y) or V = Y/(f(i,Y)).
This means that under Keynes' theory, velocity fluctuates with the interest rate. Since interest
rates fluctuate quite a bit, then velocity must too. In fact, velocity and interest rates will move in
the same direction. Both are procyclical, rising with expansions and falling during recessions.
Further Developments to the Keynesian Approach
After World War II, Keynes economic theories became very influential and other economists
further refined his motives for holding money. One of these economists, James Tobin, later won
a Nobel Prize for his contributions.
Tobin (and another economist Baumol) both developed theories and how the transactions
demand for money is also related to the interest rate. As interest rates rise, the opportunity cost of
holding cash for transactions will also rise, so the transactions part of money demand is also
negatively related to the interest rate. Similarly, people will hold fewer precautionary balances
when interest rates are high.
One problem with Keynes' speculative demand is that his theory predicted that people would
hold wealth as either money or bonds, but not both at once. That is not realistic. Tobin avoided
this problem by observing that the return to money is much less risky than the return to bonds, so
that people will still hold some money as a store of wealth even when interest rates are high. This
diversification is attractive because is reduces risk.
Still one problem with money demand remains. There are other low risk interest bearing assets:
money market mutual funds, U.S. Treasury Bills, and others. So why would anyone hold money
(M1) as a store of wealth? Economist today still try to develop models of investor behavior to
solve this "rate of return dominance" puzzle.
III. Friedman's Modern Quantity Theory of Money
Milton Friedman (another Nobel Prize winner) developed a model for money demand based on
the general theory of asset demand. Money demand, like the demand for any other asset, should
be a function of wealth and the returns of other assets relative to money. His money demand
function is as follows:
where Yp = permanent income (the expected long-run average of current and future income)
rb = the expected return on bonds
rm = the expected return on money
re = the expected return on stocks
pi(e) = the expected inflation rate (the expected return on goods, since inflation is the increase in
the price (value) of goods)
Money demand is positively related to permanent income. However, permanent income, since it
is a long-run average, is more stable than current income, so this will not be the source of a lot of
fluctuation in money demand
The other terms in Friedman's money demand function are the expected returns on bonds, stocks
and goods RELATIVE the expected return on money. These items are negatively related to
money demand: the higher the returns of bonds, equity and goods relative the return on money,
the lower the quantity of money demanded. Friedman did not assume the return on money to be
zero. The return on money depended on the services provided on bank deposits (check cashing,
bill paying, etc) and the interest on some checkable deposits.
Friedman vs. Keynes
When comparing the money demand frameworks of Friedman and Keynes, several differences
arise
• Friedman considers multiple rates of return and considers the RELATIVE returns to be
important
• Friedman viewed money and goods and substitutes.
• Friedman viewed permanent income as more important than current income in
determining money demand
Friedman's money demand function is much more stable than Keynes'. Why? Consider the terms
in Friedman's money demand function:
• permanent income is very stable, and
• the spread between returns will also be stable since returns would tend to rise or fall all at
once, causing the spreads to stay the same. So in Friedman's model changes in interest
rates have little or no impact on money demand. This is not true in Keynes' model.

If the terms affecting money demand are stable, then money demand itself will be stable. Also,
velocity will be fairly predictable.
IV. Empirical Evidence on Money Demand
So who is right? Well, the chief differences between Keynes and Friedman lie in the sensitivity
of money demand to interest rates and the stability of the money demand function over time.
Looking at the data on these two features will yield some answers about the best theory of
money demand.
Tobin did some of the earliest research on the relationship between interest rates and money
demand and concluded that money demand IS sensitive to interest rates. Later research in the
1950s and 1960s backed up his findings. Furthermore, the sensitivity did not change over time.
Many researchers looked at this question and their findings are remarkably consistent (which in
economics is somewhat miraculous :)).
Now for the stability of the money demand function. Up until the mid-1970s, researchers found
the money demand function to be remarkably stable. In other words, money demand functions
estimated in the 1930s, worked just as well predicting money demand in the 1950s or 1960s. The
relationship between money demand, income and interest rates did not change over time.
However, starting in 1974, the stability of the money demand function (M1) began to
breakdown. Existing money demand functions were overpredicting money demand (i.e. actual
money demand was lower than what old money demand functions were predicting). This case of
the "missing money" was a problem for policy makers that relied on these functions to predict
the effects of monetary policy. What caused this breakdown? It is likely that financial
innovations in the 1970s (money market accounts, NOW accounts, electronic funds transfers)
changed the working definitions of money even though our official definitions did not change.
This problem grew worse in the 1980s.
With the problems in the M1 money demand functions, policy makers turned to M2 money
demand. However, the stability of M2 money demand functions also broke down in the 1990s.
This cause the Federal Reserve to stop setting targets for M2 in 1992 after abandoning M1
targets in 1987.