BOX 18.5 CALCULATING THE MONEY MULTIPLIER ECONOMICS EXPLORING
19.1 THE EFFECTS OF MONETARY CHANGES ON NATIONAL INCOME
Interest rate transmission mechanism How a change in money supply affects aggregate demand via a change in interest rates.
Exchange rate transmission mechanism How a change in money supply affects aggregate demand via a change in exchange rates.
Definitions
In this section we examine the impact on the economy of changes in money supply and interest rates: how they affect aggregate demand and how this, in turn, affects national income. A simple way of understanding the issues is in terms of the quantity theory of money.
The quantity theory of money
In section 16.2 (pages 458–9), we looked at the following version of the quantity equation:
MV =PY
In case you did not study Chapter 16, let us state the theory again. First a definition of the terms: Mis the supply of money; Vis the income velocity of circulation (the num- ber of times money is spent per year on national output (GDP));Pis the price index (where the index =1 in the base year); and Yis the real value of national income (=national output) for the year in question (i.e. GDP measured in base- year prices).
MV is the total spending on national output. For example, if total money supply was £100 billion and each pound was spent on average five times per year on national output, then total spending on national output (MV) would equal £500 billion for that year. MVis thus simply (nominal) aggregate demand, since total spending on national output consists of the four elements of aggregate demand: consumer spending (C), investment expenditure (I), government spending (G), and expenditure on exports less expenditure on imports (X −M), all measured in cur- rent prices.
PYis the money value of national output: in other words, GDP measured at currentprices. For example, if real national income (i.e. in base-year prices) was £200 billion, and the price index was 2.5 (in other words, prices were 21/2times higher than in the base year), then the value of national output in current prices would be £500 billion.
Because of the way we have defined the terms, MVmust equal PY. A simple way of looking at this is that MVand PY are both ways of measuring GDP. MVmeasures it in terms of national expenditure. PY measures it in terms of the value of what is produced.
The effect of a change in money supply
If money supply (M) changes, how will it affect the other three elements of the quantity equation? Will a rise in money supply simply lead to a rise in prices (P), or will there be a rise in real national income (Y): i.e. a rise in real GDP? What will happen to the velocity of circulation? Can we assume that it will remain constant, or will it change?
Clearly the relationship between money supply and prices depends on what happens to Vand Y. What happens
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• Figure 19.2(c) is the Keynesian withdrawals and injec- tions diagram. A rise in investment leads to a multiplied rise in national income (from Y1to Y2). If saving fell, there would also be a downward shift in the Wline.
The rise in income will be less than that shown in Fig- ure 19.2(c), however, since any rise in income will lead to a rise in the transactions demand for money, L1. Lwill shift to the right in Figure 19.2(a), and thus rwill not fall as much as illustrated. Thus investment (Figure 19.2(b)) and national income (Figure 19.2(c)) will not rise as much as illustrated either.
The overall effect of a change in money supply on national income will depend on the size of the effect in each of the three stages. This will depend on the shapes of the curves in each of the three diagrams and whether they are likely to shift. The effect will be bigger
• the less elastic the liquidity preference curve (L): this will cause a bigger change in the rate of interest;
• the more interest-elastic the investment curve (I): this will cause a bigger change in investment;
• the lower the marginal propensity to withdraw (mpw), and hence the flatter the withdrawals function: this will
cause a bigger multiplied change in national income and aggregate demand.
The problem is that stages 1 and 2 may be both weak and unreliable, especially in the short run. This problem is stressed by Keynesians.
Problems with stage 1: the money–interest link
An interest-elastic demand for money. According to Keynes- ians, the speculative demand for money is highly respon- sive to changes in interest rates. If people believe that the rate of interest will rise, and thus the price of bonds and other securities will fall, few people will want to buy them.
Instead there will be a very high demand for liquid assets (money and near money). The demand for money will therefore be very elastic in response to changes in interest rates. This was a problem in 2008/9 when central banks around the world increased money supply in an attempt to offset the credit crunch. Many banks, firms and individuals preferred to increase the liquidity of their asset holdings rather than buy bonds, shares or houses.
In such circumstances, the demand-for-money curve (the liquidity preference curve, L) will be relatively flat and Figure 19.2 Effect of a rise in money supply: the interest rate transmission mechanism
Figure 19.1 Monetary transmission mechanisms
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may even be infinitely elastic at some minimum interest rate. This is the point where everyone believes interest rates will rise, and therefore no one wants to buy bonds.
Everyone wants to hold their assets in liquid form.
With a very gently sloping Lcurve (as in Figure 19.3), a rise in money supply from Mto M′will lead to only a small fall in the rate of interest fromr1to r2. Once people believe that the rate of interest will not go any lower, any further rise in money supply will have no effect on r. The addi- tional money will be lost in what Keynes called the liquid- ity trap. People simply hold the additional money as idle balances.
Keynes himself saw the liquidity trap as merely a special case: the case where the economy is in deep recession. In such a case, an expansion of money supply would have no effect on the economy. In more normal times, an expan- sion of money supply would be likely to have someeffect on interest rates. Nevertheless, the problem could be severe in times of recession. The Japanese economy suffered from a prolonged recession from the early 1990s to the early 2000s (see Case Study 20.6 in MyEconLab). The govern- ment and central bank expanded the money supply, but people seemed unwilling to spend. They preferred to hold idle balances. What is more, with interest rates already being virtually zero, there was little incentive to buy bonds or other assets. Thus any extra money was simply kept in idle balances – lost in the liquidity trap.
An unstable demand for money. A more serious problem for most countries is that the liquidity preference curve (L) is unstable. People hold speculative balances when they
anticipate that interest rates will rise (security prices will fall). But it is not just the current interest rate that affects people’s expectations of the future direction of interest rates. Many factors could affect such expectations:
• Changes in foreign interest rates. Domestic interest rates would have to follow suit if the authorities wished to maintain a stable exchange rate.
• Changes in exchange rates. With a falling exchange rate, the authorities may raise interest rates to prevent it depreciating further.
• Statements of government intentions on economic policy.
• Good or bad industrial news. With good news, people tend to buy shares.
• Newly published figures on inflation or money supply.
If inflation or the growth in money supply is higher than anticipated, people will expect a rise in interest rates in anticipation of a tighter monetary policy.
Thus the Lcurve can be highly volatile. With an un- stable demand for money, it is difficult to predict the effect on various interest rates of a change in money supply.
A policy of targeting money supply can be criticised for similar reasons. A volatile demand for money can cause severe fluctuations in interest rates if the supply of money is kept constant (see Figure 19.4). These fluctu- ations will cause further uncertainty and further shifts in the speculative demand for money. Targeting the money supply can therefore add to the volatility of the velocity of circulation (V).
Problems with stage 2: the interest rate–investment link
An interest-inelastic investment demand. In the 1950s and 1960s, many Keynesians argued that investment was Figure 19.3 An elastic liquidity preference curve
Liquidity trapThe absorption of any additional money supply into idle balances at very low rates of interest, leaving aggregate demand unchanged.
Definition
Figure 19.4 The effect on interest rates of a fluctuating demand for money
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unresponsive to interest rate changes: that the Icurve in Figure 19.2(b) was steep. In these circumstances, a very large change in interest rates would be necessary to have any significant effect on investment and aggregate demand.
Investment, it was argued, depends on confidence in future markets. If confidence is high, firms will continue to invest even if interest rates are high. They can always pass the higher costs on to the consumer. If confidence is low, firms will not invest even if interest rates are low and bor- rowing is cheap. Evidence seemed to confirm the interest inelasticity of investment demand.
Few Keynesians hold this extreme position today. The evidence for an inelastic investment demand has been challenged. Just because investment was not significantly higher on occasions when interest rates were low, it does not follow that investment is unresponsive to interest rate changes. There may have been changes in otherfactors that helped to curbinvestment: in other words, the Icurve shifted to the left. For example, a fall in consumer demand would both cause the low interest rate anddiscourage investment.
Figure 19.5 shows a steep investment demand curve.
If the rate of interest falls from r1to r2, there is only a small rise in investment from I1to I2. Now draw a much more elastic I curve passing through point a. Assume that this is the true I curve. Show how the rate of interest could still fall to r2and investment still only rise to I2if this curve were to shift.
Even if fixed investment in plant and machinery is not very interest sensitive, other components of aggregate demand may well be: for example, investment in stocks, consumer demand financed through credit cards, bank loans or hire purchase, and the demand for houses financed through mortgages.
An unstable investment demand. Today the major worry about the interest–investment link is not that the invest- ment curve is inelastic, but rather that it shifts erratically with the confidence of investors.
? Assume in Figure 19.6 that the initial investment
demand curve is given by I1. Now assume that the central bank reduces interest rates from r0to r1. Other things being equal, the level of investment will rise from Q0to Q1. If, however, firms believe that the economy will now pull out of recession, their confidence will increase. The investment curve will shift to I2 and investment will increase quite markedly to Q2. If, on the other hand, firms believe that inflation will now rise, which in turn will later force the central bank to raise interest rates again, their confidence may well decrease. The investment curve will shift to I3and the level of investment will actually fall to Q3.
Monetary policy is likely to be effective, therefore, only if people have confidence in its effectiveness. This psycho- logicaleffect can be quite powerful. It demands consider- able politicalskill, however, to manipulate it.
For example, in October 2008, with growing concerns around the world that there would be a serious global reces- sion, central banks in the USA, the UK, the eurozone and several other countries all cut interest rates on the same day. As we saw in section 18.2, there were also concerted attempts around the world to inject extra liquidity into the banking system. But crucial to these policy decisions was the attempt to reassure people that the measures would work. Politicians stressed that they were on top of things and that they would do whatever it took to sort out the problem. They knew that getting confidence to return was vital to the success of the policies.
The exchange rate transmission mechanism
The second transmission mechanism is the exchange rate transmission mechanism. This is illustrated in the bottom half of Figure 19.1 on page 537 and graphed in Figure 19.7.
This mechanism backs up the interest rate mechanism. It Figure 19.5 Does a fall in interest rates cause only
a small rise in investment?
Figure 19.6 The effects of interest rate changes, given an unstable investment demand curve
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includes the exchange rate as an intermediate variable between changes in the money supply and changes in aggregate demand. There are four stages in this exchange rate transmission mechanism (see Figure 19.7):
• In Figure 19.7(a), a rise in money supply causes a fall in domestic interest rates from r1to r2.
• In Figure 19.7(b), the fall in domestic interest rates leads to an increased outflow of short-term finance from the country as people demand more foreign assets instead.
These will also be a reduced inflow, as depositors seek to take advantage of relatively higher interest rates abroad.
The supply of the domestic currency on the foreign exchange market rises from S1 to S2 and the demand falls from D1 to D2. This causes a depreciation of the exchange rate from er1to er2(assuming the authorities allow it). There is a second factor contributing to the rightward shift in the supply curve: the use of part of the increased money supply to buy foreign assets directly.
What is more, the depreciation in the exchange rate may be speeded up or amplified by speculation.
• In Figure 19.7(c), the depreciation of the exchange rate causes a rise in demand for exports (X), since they are now cheaper for people abroad to buy (there is a move- ment down along the Xcurve). It also causes a fall in demand for imports (M), since they are now more expensive (there is a movement up along the Mcurve).
Note that the rise in exports and fall in imports gives
a current account balance of payments surplus. This is matched by the financial account deficit resulting from the lower interest rate encouraging people to buy foreign assets and people abroad buying fewer of this country’s assets.
• In Figure 19.7(d), the rise in exports (an injection) and a fall in imports (a withdrawal) will cause a multiplied rise in national income.
Stage 1 will tend to be more powerful than in a closed economy. The liquidity preference curve will tend to be less elastic because, as interest rates fall, people may fear a depreciation of sterling and switch to holding other curren- cies. Just how strong stage 1 will be depends on how much people think the exchange rate will depreciate.
Stage 2 is likely to be very strong indeed. Given the openness of international financial markets, international financial flows can be enormous in response to interest rate changes. Only a relatively small change in interest rates is necessary to cause a relatively large financial flow.
Monetarists and new classical economists stress the import- ance of this effect. Any fall in interest rates, they argue, will have such a strong effect on international financial flows and the exchange rate that the rise in money supply will be relatively quickly and fully transmitted through to aggregate demand.
Stage 3 may be quite strong in the long run. Given time, both the demand by consumers abroad for this country’s Figure 19.7 The exchange rate transmission mechanism
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exports and the domestic demand for imports may be quite elastic. In the short run, the effect may be rather limited.
However, the size of the effect depends on people’s expec- tations of exchange rate movements. If people think that the exchange rate will fall further, importers will buy now before the rate does fall. Exporters, on the other hand, will hold back as long as possible before shipping their exports. These actions will tend to push the exchange rate down. But such speculation is very difficult to predict as it depends on often highly volatile expectations.
If importers and exporters believe that the exchange rate has ‘bottomed out’, what will they do?
Stage 4 is the familiar multiplier, only this time triggered by a change in imports and exports.
Note that, as with the interest rate transmission mechan- ism, the full effect will not be as large as that illustrated.
This is because the increased national income will cause an increased transactions demand for money. This will shift the Lcurve to the right in Figure 19.7(a), and thus lead to a smaller fall in the rate of interest than that illustrated.
The overall effect can be quite strong, but the precise magnitude is usually highly unpredictable.
The effects of changes in money supply will depend also on just how free the exchange rate is. If the government intervenes to ‘peg’ (i.e. fix) the exchange rate or to prevent excessive fluctuations, the transmission mechanism will not work in the way described. Alternative exchange rate systems (or ‘regimes’, as they are called) are examined in Chapter 25.
Portfolio balance: a more direct transmission mechanism
Monetarists stress a more direct transmission mechanism.
If money supply increases, people will have more money than they require to hold. They will spend this surplus.
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Much of this spending will go on goods and services, thereby directly increasing aggregate demand:
Ms ↑ →Ms>Md→AD ↑
The theoretical underpinning for this is given by the theory of portfolio balance. People have a number of ways of holding their wealth: as money, or as financial assets such as bills, bonds and shares, or as physical assets such as houses, cars and televisions. In other words, people hold a whole portfolio of assets of varying degrees of liquidity – from cash to central heating.
If money supply expands, people will find themselves holding more money than they require: their portfolios are unnecessarily liquid. Some of this money will be used to purchase financial assets, and some to purchase goods and services. As more assets are purchased, this will drive up their price. This will effectively reduce their ‘yield’. For bonds and other financial assets, this means a reduction in their rate of interest. For goods and services, this means a reduction in their marginal utility/price ratio: a higher level of consump- tion will reduce their marginal utility and drive up their price.
The process will stop when a balance has been restored in people’s portfolios. In the meantime, there will have been extra consumption and hence a rise in aggregate demand.
Do you think that this is an accurate description of how people behave when they acquire extra money?
This mechanism has been criticised by Keynesians. Just how is the extra money injected into people’s portfolios in the first place? There are two possible means in the short term.
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BOX 19.1 CHOOSING THE EXCHANGE RATE OR THE MONEY SUPPLY You can’t choose both
EXPLORING ECONOMICS
techniques to do so) and let interest rates and the exchange rate be what they will. Or it can choose the exchange rate, but this will then determine the necessary rate of interest and hence the supply of money. These issues are explored in Chapter 25.
Can the government choose both the exchange rate and the money supply if it is prepared to use the reserves to support the exchange rate?
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If the government expands the money supply, then interest rates will fall and aggregate demand will tend to rise. With a floating exchange rate, this will cause the currency to depreciate.
But what if the government attempts to maintain a fixed exchange rate? To do this it must keep interest rates comparable with world rates. This means that it is no longer free to choose the level of money supply. The money supply has become endogenous.
The government can’t have it both ways. It can choose the level of the money supply (providing it has the
Portfolio balance The balance of assets, according to their liquidity, that people choose to hold in their portfolios.
Definition
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