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Money & Banking ­ MGT411
VU
Lesson 40
MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
To shift the focus to inflation, we need to look at changes in the price level.
Suppose that inflation exceeds money growth (with velocity held constant).
Real money
balances will fall and so will aggregate demand
Figure: The Aggregate Demand Curve
At higher level of inflation, real money balances fall, resulting in a lower level of
aggregate demand.
Inflation ()
Aggregate Demand Curve
Output (Y)
Because real money balances fall at higher levels of inflation, resulting in a lower level of
aggregate demand, the aggregate demand curve is downward sloping.
Changes in the interest rate also provide a mechanism for aggregate demand to slope down
Monetary Policy and the Real Interest Rate
Central bankers control short-term nominal interest rates by controlling the market for reserves.
But the economic decisions of households and firms depend on the real interest rate;
To alter the course of the economy, central banks must influence the real interest rate as well
In the short run, because inflation is slow to respond, when monetary policymakers change the
nominal interest rate they change the real interest rate.
The real interest rate, then, is the lever through which monetary policymakers influence the real
economy.
In changing real interest rates, they influence aggregate demand.
Aggregate Demand and the Real Interest Rate
Aggregate demand is divided into four components:
Consumption,
Investment,
Government purchases,
Net exports
Aggregate Govt.'s Net Demand = Consumption + Investment + Purchases + Exports
Yad = C + I + G + NX
It is helpful to think of aggregate demand as having two parts, one that is sensitive to real
interest rate changes and one that is not
Investment is the most important of the components of aggregate demand that are sensitive to
changes in the real interest rate.
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Money & Banking ­ MGT411
VU
An investment can be profitable only if its internal rate of return exceeds the cost of borrowing
Consumption and net exports also respond to the real interest rate;
Consumption decisions often rely on borrowing, and the alternative to consumption is saving
(higher rates mean more saving).
As for net exports, when the real interest rate in a country rises, her financial assets become
attractive to foreigners, causing local currency to appreciate, which in turn means more imports
and fewer exports (lower net exports)
While changes in real interest rate may have an impact on the government's budget by raising
the cost of borrowing, the effect is likely to be small and ignorable.
Thus, considering consumption, investment, and net exports, an increase in the real interest rate
reduces aggregate demand (the effect on the 4th component, government spending, is small
enough to be ignored).
Impact of rise in the Real interest rate on Components of Aggregate Demand
Components of
Effect of a rise in the real interest
Impact on component
Aggregate Demand
rate
of Aggregate Demand
Consumption (C)
Reward to saving rises
Consumption falls
Investment (I)
Cost of financing rises
Investment falls
Net Exports (NX)
Demand for domestic assets rises,
Exports fall; imports
causing a currency appreciation,
rises; net exports fall
raising the price of exports and
reducing the cost of imports
Aggregate Demand (Yad)
C, I and NX all fall
Aggregate demand falls
The Long-Run Real Interest Rate
There must be some level of the real interest rate at which aggregate demand equals potential
output; this is the long-run real interest rate.
The long-run real interest rate equates aggregate demand with potential output.
The rate will change if a component of aggregate demand that is not sensitive to the real interest
rate goes up (or down) or if potential output changes.
For example, an increase in government purchases (all else held constant) will raise aggregate
demand at every level of the real interest rate.
To remain in equilibrium, one of the interest-sensitive components of aggregate demand must
fall, and for that to happen, the long-run real interest rate must rise.
The same would be true for increases in other components of aggregate demand that are not
interest sensitive.
A change in potential output has an inverse effect on the long-run real interest rate;
When potential output rises, aggregate demand must rise with it, which requires a decrease in
the real interest rate
Inflation, the Real Interest Rate, and the Monetary Policy Reaction Curve
Policymakers set their short-run nominal interest rate targets in response to economic conditions
in general and inflation in particular.
When current inflation is high or current output is running above potential output, central
bankers will raise nominal interest rates; when current inflation is low or current output is well
below potential, they will lower interest rates
While they state their policies in terms of nominal rates they do so knowing that changes in the
nominal interest rate will eventually translate into changes in the real interest rate, and it is those
changes that influence the economic decisions of firms and households
Experts agree that any (coherent) monetary policy can be written as an inflation target plus a
response to supply shocks
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY