ECON10003 Lecture Notes - Lecture 13: Nominal Interest Rate, Real Interest Rate, Inflation Targeting

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amaranthbadger280

19 Jun 2018

School

University of Melbourne

Department

Economics

Course

ECON10003

Professor

Graham Richards

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MACROECONOMICS WEEK 7

Demand for Money: The demand for money is an issue about the form in which wealth holders want to hold their

wealth. The rate of return on all other assets should influence the demand for money. One nominal rate is assumed and

is the rate of return on a non-money substitute referenced as a bond, these bonds are interest bearing securities. The

demand for money is determined by the cost-benefit principle. Benefits include convenience, liquidity and has low-

risk. The amount needed will affect the ability to undertake transactions without money (cards), the level of real

income, and the price level influencing the value or products. As the general price level rises, more money is needed

to buy the same quantity. The demand for money in money terms will be proportional to the general price level. A

larger quantity of G&S mean more money is required. Higher real income = higher expenditure = higher demand for

money. However not all proportional- come countries have debit cards etc. The cost of demanding and holding money

as an asset is the opportunity cost- the interest forgone from not holding it in an interest-bearing account/security.

Demand function for money: or In real terms.

Where i is the nominal interest rate. And/P is the demand for real money balances.

Nominal interest rate: = (dollar payment per year / price of bond) x 100.

The bond has a legal promise to pay back what has been borrowed- a debt. Through issuing bonds, the government

and larger firms are able to borrow money directly from lenders without the need of a financial intermediary. Once

they are issued they are able to be traded on a secondary market. Bond prices and interest rates have an inverse

relationship. Due to this, fluctuations in one will bring fluctuations in another.

Achieving Money Market Equilibrium: as money supply increases, wealth holders will try and rid unnecessary

money balances through buying bonds. This will increase bond price and lower nominal interest rate, which in turn

increases the desire to hold assets in the form of money.

Monetary Policy in Australia: Inflation Targeting: objective of bank if to keep CPI inflation between 2 and 3% over

the course of a cycle. The instrument of the policy is the cash rate/official interest rate/nominal interest rate which the

RBA can control and change to influence private sector spending to achieve its inflation objective. Changes in cash

rates will automatically transmit to other market interest rates. Keeping actual overnight cash rate close to the target

cash rate (specified by RBA), the bank engages in open market operations. Actual cash rate (determined by inter-bank

market) is the rate of interest paid and charged between banks and other financial institutions for overnight unsecured

borrowing and lending.

Exchange Settlement Accounts (ESA’s) provide a basis for the settlement of payments obligations to be made

between banks, mediated by the RBA. These inter-bank transfers are made as the RBA credits and debits ESA’s of the

appropriate banks. The RBA’s control over the supply of these ESA funds enables it to maintain actual cash rate on

most days of the year. If net payments are made to the RBA from the exchange settlement accounts, there is an

upwards pressure on the actual cash rate. To prevent this. The RBA adds to the supply of liquidity through buying

government securities, paying for them via crediting and the commercial banks exchange settlement accounts.

Announced rises in the target cash rate makes banks want to hold more funds as reserves in ESA’s. RBA pays on

these deposits 25 basis points below the target cash rate. The demand by banks for the monetary base, in the form of

increases ESA deposits has increased. This means there are less funds to hold in the overnight market and so the cash

rate in the overnight market will rise due to banks who wish to borrow overnight are faced with a shortage of funds

and offer to pay a higher rate.

When the price of bills is high, it follows their interest rate is low. More firms will wish to borrow more and the

supply of bills will be high. The demand curve reflects those wishing to lend for short periods of time and when the

price of bills is high they will wish to lend less as there is a lower interest rate. It is the real interest rate which

influences the expenditure decisions of the private sector.

The Taylor Rule: Recommends tightening interest rate (r) if y increases relative to y* or if inflation () increases.

The second term 0.5(y*-y/y*) can be considered as an aspect of pro-active policy.

Fighting Inflation: The effects of an increase in the cash rate by the Reserve Bank designed to raise the real interest

rate and decrease private sector. It operates to eliminate an expansionary output gap Y>Y*.

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Document Summary

Demand for money: the demand for money is an issue about the form in which wealth holders want to hold their wealth. The rate of return on all other assets should influence the demand for money. One nominal rate is assumed and is the rate of return on a non-money substitute referenced as a bond, these bonds are interest bearing securities. The demand for money is determined by the cost-benefit principle. Benefits include convenience, liquidity and has low- risk. The amount needed will affect the ability to undertake transactions without money (cards), the level of real income, and the price level influencing the value or products. As the general price level rises, more money is needed to buy the same quantity. The demand for money in money terms will be proportional to the general price level. A larger quantity of g&s mean more money is required. Higher real income = higher expenditure = higher demand for money.

Related Questions

Choose the correct answer from the brackets:

A)The demand for money is mainly influenced by three variables: r (the short-term interest rate), Y (real GDP), and P (the aggregate Price level). Suppose r rises, but Y and P are unchanged. What happens to the quantity of money demanded?

r is both the opportunity cost of holding money and the reward for holding bonds. Thus, an increase in r causes people to want to hold (more/less ) of their wealth in the form of money and ( more/less) in the form of bonds to take advantage of the higher interest rate.

Suppose real income (Y) rises while the quantity of money in the economy stays the same. What happens to money demand?

The supply of money does not automatically rise when the production of real goods and services (Y) rises. However, the collective demand for money by firms and households does rise. To get this money firms and households attempt to (buy more/ sell some of their /more /less bonds).

Thus, an increase in Y causes people to want to hold (buy more /sell some of their / more /less) of their wealth in the form of money and (buy more / sell some of their / more / less ) in the form of bonds.

C)Suppose the price level (P) rises, but Y and r are unchanged. What happens to money demand?

If Y is unchanged, people will want to buy the same amount of goods and services as before. However, since P is higher, they will need (more / less) money to do so.

Hence, an increase in P causes people to want to hold (more / less) of their wealth in the form of money and (more / less) in the form of bonds.

purplesardine140

Question 1

The higher the capital utilization rate, the greater the depreciation rate.

True

False

Question 2

Higher capital utilization rates may raise the user costs of capital because higher utilization rates imply

operating at inconvenient times.

paying overtime to employees operating the machines.

operating when complementary services like transporters are unavailable or more expensive.

All of the above.

Question 3

If the rental price of capital increase, the capital utilization rate

increases.

decreases.

remains the same.

depends on whether the substitution rate is greater than the income effect

Question 4

The vacancy rate in the labor market is

the number of job openings divided by the number of unemployed people in the labor force.

the number of job openings divided by the number of workers in the labor force.

the ratio of open jobs to filled jobs.

the ratio of open jobs to the total number of jobs that employers want occupied.

Question 5

Unemployment can exist in a market clearing model if it takes some search time for workers to find jobs.

True

False

Question 6

A decrease in workersâ effective real incomes while they are unemployed will

lower the job finding rate and raise the expected duration of unemployment.

lower the job finding rate and the expected duration of unemployment.

raise the job finding rate and lower the expected duration of unemployment.

raise the job finding rate and the expected duration of unemployment.

Question 7

In the Barro model, the natural rate of unemployment is

zero.

fixed.

Question 8

If the interest rate increases, the real demand for money also increases

True

False

Question 9

Commodity money is money that has value because

of the intrinsic value of the commodity.

it is legal tender.

the government says so.

All of the above.

Question 10

High-powered money is

money held by business for investment.

total currency in circulation plus depository institution deposits at the Fed.

total currency in circulation.

government bonds held by the public and depository institutions.

Question 11

U.S. M1 money includes

currency held by the public.

checkable deposits.

travelerâs checks.

All of the above.

Question 12

U.S. M2 money includes

currency, time deposits, and government bonds.

savings deposits, small time deposits, and private bonds.

checkable deposits, savings deposits, and small time deposits.

retail money market mutual funds, small time deposits, and government bonds.

Question

Money is different from other assets like capital and bonds in that

money does not pay interest.

money has intrinsic value.

money is a better long term store of value.

All of the above.

Question

If a personâs income doubles, we expect their cash holdings to

Question 15

Real money demand does not change when

nominal GDP changes.

the interest rate changes.

the price level changes.

All of the above.

Question 16

All else constant, the price level rises when the supply of money increases.

True

False

Question 17

If the nominal interest rate were to increase, then

money demand decreases and the price level increases.

money demand increases and the price level decreases.

the money supply and the price level would increase.

the money supply and the price level would decrease.

Question 18

Real money demand is a function of real GDP and the nominal interest rate.

True

False

Question 19

The real return on money is zero.

True

False

Question 20

If the expected inflation rate is 5% and the unexpected inflation rate is 4%, the actual inflation is

-1%

1.25%

Question 21

When the rate of growth of money is constant

the inflation rate equals the growth rate of money.

the nominal interest rate rises.

real money balances are declining.

All of the above.

Question 22

A decrease in the money growth rate in the market clearing model causes

a decrease in the nominal interest rate.

an increase in money demand.

a decrease in the price level.

All of the above.

Question 23

A decrease in the money growth rate in the market clearing model causes

an increase in the nominal interest rate.

an increase in money demand.

an increase in the price level.

All of the above.

Question 24

Under price level targeting the money supply becomes

Q 25 During a recession, the interest rate falls tending to cause money demand to rise, but is at least partly offset by real GDP falling tending to cause money demand to fall.

True

False

The demand for money
A) d and e are correct
B) all of the following are correct
C) decreases as the average selling price of a unit of outputincreases
D) increases as GDP increases
E) is increased by credit card usage
2. The higher the interest rate, the more of their wealth peoplewill hold as money.
A) True
B) False
3. The money demand curve slopes
A) downward because the cost of holding money decreases as theinterest rate decreases
B) downward because the cost of holding money increases as theinterest rate decreases
C) upward because people demand more money as GDP increases
D) upward because people demand more money as GDP decreases
E) downward because people demand more money as the price levelincreases
4. Which of the following, other things constant, will shift themoney demand curve to the left?
A) an increase in the interest rate
B) a decrease in the interest rate
C) a decrease in real GDP
D) an increase in real GDP
E) an increase in the price level
5. An increase in the money supply will
A) increase the demand for money at each interest rate
B) decrease the demand for money at each interest rate
C) lead people to try to exchange money for interest-bearingassets
D) lead people to try to exchange interest-bearing assets formoney
E) increase the interest rate
6. When an increase in the money supply reduces the interest rate,investment and nominal GDP increase.
A) True
B) False
7. In the short run, a decrease in the money supply will cause adecrease in Gross Domestic Product and a decrease in the pricelevel.
A) True
B) False
8. The demand curve for investment is graphed with __________ onthe vertical axis and __________ on the horizontal axis.
A) the interest rate; investment
B) investment; the interest rate
C) the price level; investment
D) investment; the price level
E) real GDP; investment
9. As the interest rate increases,
A) the demand for investment curve shifts to the right
B) the demand for investment curve shifts to the left
C) there is a movement downward along the demand for investmentcurve
D) there is a movement upward along the demand for investmentcurve
E) GDP increases
10. If the economy experiences a contractionary gap and the Fedstimulates the economy, then:
A) The money supply is increasing because the Fed prints moremoney
B) The money supply is decreasing because the Fed hoardsmoney
C) The money supply is increasing because the Fed makes open-marketpurchases
D) The money supply is decreasing because the Fed makes open-marketsales
E) There is no change in the money supply because the Fed cannotinfluence the money supply
11. If the Fed decreases the money supply, GDP
A) increases because the resulting increase in the interest rateleads to a decrease in investment
B) increases because the resulting decrease in the interest rateleads to an increase in investment
C) decreases because the resulting increase in the interest rateleads to a decrease in investment
D) decreases because the resulting increase in the interest rateleads to an increase in investment
E) decreases because the resulting decrease in the interest rateleads to an increase in investment
12. An increase in the money supply can increase the price level,real GDP, or both, but it is impossible to tell exactly what willhappen without knowing the slope of the aggregate supplycurve.
A) True
B) False
13. If the economy experiences an expansionary gap and the Fedsells US government securities in the open-market, then:
A) Money supply increases, investment increases, aggregate demandincreases
B) Money supply increases, the interest rate increases, and theaggregate demand increases
C) Money supply decreases, the interest rate decreases, and theaggregate demand falls
D) Money supply decreases, the investment decreases, and theaggregate demand decreases
E) Interest rate falls, investment falls, aggregate demandincreases
14. If the money supply equals $1,000 and nominal GDP equals$3,000, then V
A) equals 1/3
B) equals 3
C) equals 3 million
D) cannot be determined since we do not know anything aboutprices
E) cannot be determined since we do not know anything about realGDP
15. If the money supply is increasing at a constant 8 percent,velocity is constant, real GDP is increasing at 5 percent, and theinflation rate is 3 percent, which of the following is true?
A) The growth rate of GDP is too low to be maintained.
B) The inflation rate is too low to be maintained.
C) Velocity is too low to be maintained.
D) The money supply growth rate is too low to be maintained.
E) This situation can continue indefinitely.
16. If real output and velocity are stable and predictable, thenthe equation of exchange can be used to derive a simplerelationship between
A) the money supply and the price level
B) the money supply and the interest rate
C) the money supply and the foreign exchange rate
D) velocity and real GDP
E) velocity and nominal GDP
17. For the quantity theory of money to yield usefulpredictions,
A) fiscal policy must be ineffective in altering aggregatedemand
B) fiscal policy must be effective in altering aggregatedemand
C) the economy must be operating at the potential level of realGross Domestic Product
D) velocity must be stable or predictable
E) velocity must be unstable
18. A rising rate of inflation
A) makes people more willing to hold money as an asset
B) reduces the usefulness of money as a store of value and thusincreases the velocity of money
C) increases the usefulness of money as a medium of exchange andthus reduces the velocity of money
D) is usually preceded by a reduction in the money supply
E) does not, apparently, have any effect on the velocity ofmoney
19. There is considerable disagreement about whether the Fedshould
A) engage in open market operations
B) have the power to set reserve requirements
C) reduce the money supply when the economy is growing
D) allow banks to invest in the stock market
E) attempt to control interest rates or should instead attempt tocontrol the money supply
20. For interest rates to remain stable during economic expansions,the growth rate of the money supply should
A) exceed the growth in the demand for money
B) just match the growth in the demand for money
C) be less than the growth in the demand for money
D) be zero
E) just match the growth in nominal GDP

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ECON10003 Lecture Notes - Lecture 13: Nominal Interest Rate, Real Interest Rate, Inflation Targeting

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