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11 MONEY, INTEREST,REAL GDP, ANDTHE PRICE LEVEL*

K e y C o n c e p t s

The Demand for Money

Four factors influence the demand for money:

♦ The price level — An increase in the price level in-creases the nominal demand for money.

♦ The interest rate — An increase in the interest rateraises the opportunity cost of holding money and

decreases the quantity of real money demanded.

♦ Real GDP — An increase in real GDP increases thedemand for money.

♦ Financial innovation — Innovations that lower thecost of switching between money and other assetsdecrease the demand for money.

Figure 11.1 shows the demand for money curve ( MD ).The real quantity of money equals the nominal quan-tity divided by the price level. Changes in the interestrate create movements along the demand curve;changes in the other relevant factors change the de-mand and shift the demand curve.

Interest Rate Determination

An interest rate is the percentage yield on a financialsecurity; other variables being the same, the higher theprice of the security, the lower is the interest rate.

The interest rate is determined by the equilibrium inthe market for money, as illustrated in Figure 11.2.The real supply of money is $3.0 trillion, so the supply curve of money is MS . The demand curve for money is MD , and the equilibrium interest rate is 5 percent.

♦ If the Fed increases the quantity of money, thesupply of money curve shifts rightward and the

equilibrium interest rate falls. If the Fed decreasesthe quantity of money, the supply of money curveshifts leftward and the equilibrium interest rate rises.

* This is Chapter 27 in Economics .

C h a p t e r

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1 6 4 C H A P T E R 1 1 ( 2 7 )

Short-Run Effects of Money on Real GDP

and the Price Level

The Fed’s actions ripple through the economy. Higherinterest rates:

♦ Decrease investment and consumption expenditure

♦ Increase the foreign exchange price of the dollar, which then decreases net exports

♦ A multiplier process then occurs

Real GDP growth and the inflation rate both slow when the Fed raises the interest rate. The opposite ef-fects occur when the Fed lowers the interest rate. Theseeffects are how the Fed influences the economy.

The macroeconomic short run is a period during whichsome money prices are sticky and real GDP might bebelow, above, or at potential GDP.

If real GDP exceeds potential GDP so there is an infla-tionary gap, the Fed tightens to avoid inflation. The

Fed decreases the quantity of money, which raises theinterest rate. The higher interest rate decreases interest-sensitive components of aggregate expenditure, such asinvestment. The decrease in investment leads to a mul-tiplier effect that decreases aggregate demand, thereby lowering the price level and decreasing real GDP so itequals potential GDP. If the Fed eases to avoid a reces-sion, the reverse results occur.

Long-Run Effects of Money on Real GDP

and the Price Level

The macroeconomic long run is a period that is suffi-

ciently long for the forces that move real GDP towardpotential GDP to have had their full effects.

♦ Suppose the economy is at its long-run equilibriumand the Fed increases the quantity of money. Ag-gregate demand increases and the AD curve shiftsrightward, as illustrated in Figure 11.3. The pricelevel rises, and real GDP increases.

♦ An inflationary gap exists and the unemploymentrate is below than the natural rate. The tight labormarket leads to a rise in the money wage rate. Theshort-run aggregate supply decreases, and the short-

run aggregate supply curve shifts from SAS 0

to

SAS 1. This situation is illustrated in Figure 11.4, wherein real GDP returns to potential real GDP($10 trillion) and the price level rises still higher to130.

The quantity theory of money holds that, in the long run, an increase in the quantity of money brings anequal percentage increase in the price level.

The velocity of circulation is the average number of times a dollar of money is used in a year to buy goodsand services in GDP. In terms of a formula, velocity of

circulation, V , is given by V = PY/M, where P is theprice level, Y is real GDP, and M is the quantity of money. M1 velocity has increased and fluctuated butM2 velocity has been quite stable.

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M O N E Y , I N T E R E S T , R E A L G D P , A N D T H E P R I C E L E V E L 1 6 5

The equation of exchange shows that the quantity of money multiplied by velocity equals (nominal) GDP,or

MV = PY .

The quantity theory makes two assumptions:

♦ Velocity is not affected by the quantity of money.

♦ Potential GDP is not affected by the quantity of money.

With these assumptions, the equation of exchange

shows that , M

M

P

P ∆=

∆which means that the percent-

age increase in the price level (the inflation rate) equalsthe percentage increase in the quantity of money.

The AS/AD model also predicts that, in the long run,an increase in the quantity of money causes the samepercentage increase in the price level. However, theone-to-one relationship does not hold in the short run.

Historical evidence from the United States and interna-tional evidence both show that in the long run, themoney growth rate and inflation rate are positively related and that the year-to-year relationship is weaker.

H e l p f u l H i n t s

1. USE OF THE QUANTITY THEORY : Analysts oftenuse the quantity theory to help shape their thinking about the future inflation rate by using the rate of growth of the quantity of money to help predict

whether the inflation rate is likely to rise or fall.

Even though the relationship between the growthrate of the quantity of money and the inflation ratemight not be one-to-one as suggested by the quan-tity theory, nonetheless the correlation betweenhigher monetary growth rates and higher inflationrates is quite substantial.

You, too, can use this relationship to help predictthe inflation rate. For instance, if you note that thegrowth rate of the quantity of money has jumpedsharply higher, you should expect higher inflationrates to occur. Because interest rates tend to in-crease with the inflation rate, you would want toobtain loans with fixed (nominal) interest rates asquickly as possible. Conversely, you would not

want to enter into long-term savings contracts withfixed interest rates.

Q u e s t i o n s

True/False and Explain


11. The price level is the opportunity cost of holding money.

12. An increase in real GDP increases the demand formoney.


13. If the Fed buys government securities, it lowers theinterest rate.

14. If both the supply and demand for money increase,the interest rate definitely rises.

Short-Run Effects of Money on Real GDP and the

Price Level

15. Higher interest rates affect consumption expendi-ture, investment, and net exports.

16. To fight inflation, the Fed will decrease the quan-tity of money.

17. An increase in the quantity of money increasesaggregate demand.

18. In the short run, an increase in the quantity of money decreases short-run aggregate supply.

Long-Run Effects of Money on Real GDP and the

Price Level

19. If the economy is at potential GDP, in the shortrun an increase in the quantity of money lowers theunemployment rate so it is less than the naturalrate.

10. In the long run, an increase in the quantity of money decreases short-run aggregate supply.

11. Velocity equals MY/P .

12. Since 1960, M2 velocity has increased more rapidly than M1 velocity has.

13. The quantity theory of money predicts that infla-tion is caused by rapidly growing velocity.

14. Almost surely, high inflation rates cause highmonetary growth rates.

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Multiple Choice


11. An increase in ____ decreases the quantity of money people want to hold.

a. the price level

b. real GDPc. the interest rated. the quantity of money

12. Which of the following does NOT directly shift thedemand for money curve?

a. A change in GDP.b. A change in the quantity of money.c. Financial innovation.d. None of the above because they all directly shift

the demand for money curve.

13. Since 1970, in the United States the demand curve

for M2 money has shifteda. rightward in all but 2 years.b. leftward in all but 2 years.c. rightward in most years until 1989 and then

leftward in a few years and rightward in most.d. leftward in most years until 1989 and then

rightward in some years and leftward in others.


14. If the price of an asset rises and the amount paid onthe asset does not change, what happens to the in-terest rate on the asset?

a. It risesb. It does not changec. It fallsd. The premise of the question is wrong because

changes in the price of an asset have nothing todo with the interest rate paid on the asset.

15. If the interest rate exceeds the equilibrium interestrate, then people ____ bonds and the interest rate____.

a. buy; risesb. buy; fallsc. sell; rises

d. sell; falls

16. Taken by itself, an increase in the quantity of money

a. raises the interest rate.b. does not change the interest rate.c. lowers the interest rate.d. perhaps raises or perhaps lowers the interest rate,

depending on whether the demand curve for

money has a negative or a positive slope.

17. If real GDP increases, the demand for money curveshifts

a. leftward and the interest rate rises.b. leftward and the interest rate falls.c. rightward and the interest rate rises.d. rightward and the interest rate falls.


Price Level

18. If the Fed increases the interest rate, then

a. investment and consumption expenditure de-crease.

b. the price of the dollar rises on the foreign ex-change market and so net exports decrease.

c. a multiplier process that affects aggregate de-mand occurs.

d. All of the above answers are correct.

19. In order to combat inflation, the Fed will ____ thequantity of money and ____ the interest rate.

a. increase; raiseb. increase; lowerc. decrease; raise

d. decrease; lower.

10. To eliminate an inflationary gap, the Fed will ____the quantity of money and ____ aggregate demand.

a. increase; increaseb. increase; decreasec. decrease; increased. decrease; decrease

11. The Fed’s actions to fight a recession shift the

a. aggregate demand curve rightward.b. aggregate demand curve leftward.c. short-run aggregate supply curve rightward.

d. short-run aggregate supply curve leftward.

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12. In the short run, an increase in the quantity of money shifts the

a. AD curve rightward.b. SAS curve rightward.c. LAS curve rightward.d. The answer is none of the above because an in-

crease in the quantity of money does not shiftthe AD , SAS , or LAS curves.

13. In the short run, an increase in the quantity of money ____ the price level and ____ real GDP.

a. raises; increasesb. raises; does not changec. raises; decreasesd. does not change; increases


Price Level

14. In the long run, an increase in the quantity of

money

a. shifts the AD curve leftward.b. shifts the SAS curve rightward.c. shifts the SAS curve leftward.d. does not shift the AD curve.

15. In the long run, an increase in the quantity of money ____ the price level and ____ real GDP.

a. raises; increasesb. raises; does not changec. raises; decreasesd. does not change; increases

16. The quantity theory of money is the idea that

a. the quantity of money is determined by banks.b. the quantity of money serves as a good indicator

of how well money functions as a store of value.c. the quantity of money determines real GDP.d. in the long run, an increase in the quantity of

money causes an equal percentage increase in theprice level.

17. The equation of exchange is

a. MV = PY .b. MP = VY .

c. MY = PV .d. M/Y = PV .

18. Velocity equals

a. YM/P .b. PM/Y .c. PY/M .d. M/PY .

19. Nominal GDP, PY , is $6 trillion. The quantity of money is $2 trillion. Velocity is

a. 6 trillion.b. 12.c. 3.d. 2.

20. Historical evidence shows that higher monetary growth rates are associated with

a. higher inflation rates.b. no change in the inflation rate.c. lower inflation rates.d. higher growth rates of real GDP.

Short Answer Problems

1. Initially, the market for money is in equilibrium, asillustrated in Figure 11.5. Then, the Fed increasesthe quantity of money by $100 billion.

a. Draw this increase in Figure 11.5.b. What was the initial equilibrium interest rate?

What happens to the equilibrium interest rate?

c. Explain, in general, the adjustment process tothe new equilibrium interest rate.

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T AB L E 11 . 1

The Demand For Money

Interest rate

(percent per year)

Quantity of

money demanded

(billions of dollars)

3 $6004 500

5 400

6 300

2. Table 11.1 gives data on the demand for money.

a. Suppose that the equilibrium interest rate is 6percent. What is the quantity of money?

b. Suppose that the Fed wants to lower the interestrate to 4 percent. By how much must it changethe quantity of money? Is the open market op-eration is necessary to lower the interest rate anopen market purchase or sale of government se-curities?

3. In Figure 11.6 show how an increase in the quan-tity of money affects the price level and quantity of real GDP in the short run and the long run. Labelthe short-run equilibrium point a and the long-run

equilibrium point b.

T AB L E 11 . 2

Quantity Theory

Money, M

(billions of

dollars)

Velocity,

V

Price level,

P

Real GDP, Y

(trillions of

dollars)

____ 6 1.00 $6$500 6 ____ 3

550 6 ____ 3

605 6 ____ 3

4. a. Complete Table 11.2.

b. Between the second and third rows of Table11.2, what is the percentage increase in thequantity of money? What is the inflation rate?

c. Between the third and fourth rows of Table11.2, what is the percentage increase in thequantity of money? What is the inflation rate?

d. Comment on your answers to parts (b) and (c).

You’re the Teacher

1. Your friend is talking: “When the Fed increases thequantity of money, it usually does so by an openmarket operation and buys government securities.In fact, the Fed buys a lot of government securities,and these securities all pay interest to the Fed. TheFed pays for them by printing Federal Reservenotes and increasing banks’ reserves. But neitherFederal Reserve notes nor banks’ reserves pay any interest. So the Fed gets a lot of interest income

and has no interest expense. It seems to me thatthis would be very profitable. Is it? And, if it is,

what does the Fed do with the profit?” These areinteresting questions; perhaps your friend thinksthat the Fed spends its profits on the “mother of allparties” and would like to be invited. Tell yourfriend to forget about the party by explaining theprofits and what happens to them.

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A n s w e r s

True/False Answers


11. F The interest rate is the opportunity cost of hold-ing money.

12. T An increase in real GDP means more transac-tions occur and increases the demand formoney.


13. T When the Fed buys government securities, thequantity of money increases and the interest ratefalls.

14. F If the increase in the demand for money is largerthan the increase in the supply, the interest raterises. But if the increase in the supply exceedsthe increase in demand, the interest rate falls.


Price Level

15. T Higher interest rates ripple through the econ-omy, affecting many sectors.

16. T By decreasing the quantity of money, aggregatedemand decreases which lowers the price level.

17. T Changing aggregate demand is part of the rippleeffect of monetary policy.

18. F In the short run, short-run aggregate supply doesnot change.


Price Level

19. T In the short run, an increase in quantity of money increases real GDP and lowers the un-employment rate.

10. T In the long run, an increase in the quantity of money raises money wage rates and decreasesshort-run aggregate supply.

11. F Velocity equals PY/M .

12. F Since 1963, M2 velocity has not changed much, while M1 velocity has increased and fluctuated.

13. F The quantity theory predicts that inflation iscaused by growth in the quantity of money.

14. F Almost surely, the reverse is true: High mone-tary growth rates cause high inflation rates.

Multiple Choice Answers


11. c The interest rate is the opportunity cost of hold-ing money, so an increase in the interest rate re-duces the quantity of money demanded.

12. b Changes in the quantity of money create move-ments along the demand for money curve; they do not shift the curve.

13. c Until about 1989, growth in real GDP generally increased the demand for M2. Since 1989, in-novation has decreased the demand for M2

while GDP growth has increased it.


14. c There is an inverse relationship between theprice of an asset and the interest rate paid on theasset.

15. b When the interest rate exceeds the equilibriuminterest, there is an excess supply of money. Peo-ple use the excess supply to buy bonds, thereby driving the interest rate lower.

16. c An increase in the quantity of money creates a surplus of money at the initial interest rate and,as people buy financial assets to be rid of thesurplus, the price of financial assets rises, whichdrives down their interest rates.

17. c An increase in GDP increases the demand formoney and, as the demand curve shifts right-

ward, the equilibrium interest rate rises.

Short-Run Effects of Money on Real GDP and thePrice Level

18. d Each of the answers describes one of the ripplesfrom the Fed’s policy.

19. c By decreasing the quantity of money and raising the interest rate, the Fed decreases aggregate de-mand.

10. d An inflationary gap means that real GDP ex-ceeds potential GDP, so decreasing the quantity of money decreases aggregate demand and realGDP.

11. a By shifting the aggregate demand curve right-

ward, the Fed increases real GDP, thereby off-setting the recession.

12. a An increase in the quantity of money increasesaggregate demand, thereby shifting the AD curverightward.

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1 7 0 C H A P T E R 1 1 ( 2 7 )

13. a The AD curve shifts rightward so in the shortrun the economy moves along an (upward slop-ing) SAS curve to a higher price level and in-creased real GDP.


Price Level14. c In the long run, the tight labor market leads to a

rise in the money wage rate so the SAS curveshifts leftward.

15. b In the long run, the AD curve shifts rightwardand the economy moves along its (vertical) LAS curve, so the price level rises but real GDP doesnot change.

16. d The quantity theory traces the cause of inflationto monetary growth.

17. a This answer is the definition of the equation of exchange.

18. c The equation of exchange, MV = PY , can berearranged to show that velocity equals PY/M .

19. c The answer to this question can be calculatedusing the formula in the previous question. In-tuitively, velocity equals the number of times anaverage dollar is spent on goods and services inGDP.

20. a Historical evidence supports the general thrustof the quantity theory.

Answers to Short Answer Problems

1. a. Figure 11.7 shows the $100 billion increase in

the quantity of money as the rightward shiftfrom MS

0to MS

1.

b. The initial interest rate was 6 percent; after theincrease in the quantity of money, the equilib-rium interest rate fell, to 4 percent.

c. An increase in the quantity of money meansthat, at the initial interest rate (6 percent), thequantity of money supplied is greater than thequantity of money demanded. Money holders

want to reduce their money holdings and do soby buying financial assets, such as bonds. Theincrease in the demand for financial assets raises

the price of financial assets and thereby lowerstheir interest rate. As the interest rate falls, thequantity of money demanded increases, which

reduces the excess supply of money. This processcontinues until the interest rate has fallen suffi-ciently so that the quantity of money demandedis the same as the quantity of money supplied.The interest rate that sets the new quantity of money supplied equal to the quantity of money demanded is the (new) equilibrium interest rate.

2. a. When the interest rate is 6 percent, the quantity of money demanded is $300 billion. Hence thequantity supplied also must be $300 billion.

b. In order to reduce the interest rate to 4 percent,the Fed must increase the quantity of money

supplied to $500 billion. So the quantity of money must increase by $200 billion. In orderto increase the quantity of money, the Fed mustpurchase government securities.

3. Figure 11.8 (on the next page) shows the short-runand long-run impacts of an increase in the quantity of money. The increase in the quantity of money shifts the AD curve rightward. In the short run, themoney wage rate does not change and the economy

moves along SAS 0

to the new equilibrium point a .

The price level rises (to P 1 from P

0) and real GDP

increases (to GDP1

from GDP0

). However, as time

passes, the money wage rate starts to rise. Thischange shifts the SAS curve leftward until eventually

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the economy reaches its long-run equilibrium atpoint b. In the long run, the price level is (much)

higher than initially (to P 2

versus P 0), and the level

of real GDP has returned to the initial level, poten-

tial GDP, which is equal to GDP0.

T AB L E 11 . 3

Quantity Theory

Money, M

(billions of

dollars)

Velocity,

V

Price level,

P

Real GDP, Y

(trillions of

dollars)

$1000 6 1.00 $6

500 6 1.00 3

550 6 1.10 3

605 6 1.21 3

4. a. Table 11.3 completes Table 11.2. All the an-swers were calculated with the equation of ex-change, MV = PY . For the first row, to calculate M , the equation of exchange was rearranged as

M= PY/V so that M equals $1,000 billion ($1trillion). For the following rows, the equation of exchange was rearranged to show that MV/Y =P .

b. Going from the second to the third row, thequantity of money grows by 10 percent, and

(with constant velocity and real GDP) the pricelevel grows by 10 percent, that is, the inflationrate is 10 percent.

c. Moving from the third to the fourth row showsthat another 10 percent increase in the quantity of money results in another 10 percent growthin the price level.

d. The last three rows illustrate the quantity theory of money conclusion: A 10 percent increase inthe quantity of money raises the price level by 10 percent.

You’re the Teacher

1. “This is a couple of great questions. Here are a cou-ple of great answers! Sure, the Fed makes a lot of ‘profit’ and for exactly the reasons you stated: Itearns a lot of interest income on its government se-curities and it pays no interest expense. But the Feddoesn’t do anything wild and crazy with its profit:There’s not a party to die for. Instead, the Fed paysits costs with its revenue. However, the amount of revenue easily covers those costs, so what happens tothe extra? The Fed gives it back to the Treasury.That’s right, the Fed sends the extra profit back tothe U.S. Treasury so the Treasury can use it as reve-nue to help pay for the government’s expenditures.”

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