I am reading Mankiw’s ‘Macroeconomics’ now, and the author while explaining the LS curve(which deals with the money market under fixed price level in the economy) says that when the Fed decreases the money supply, interest rates rise. Yes, sounds good, new money depresses interest rates. But Mankiw uses the same logic in the graph(figure 10-13 on page no. 276; 278/462) that relates money demand(demand for real money balances) and the interest rate. As the Fed decreases the money supply, he shows that interest rate increases as there is lesser money now to be had as real money balances(note: price level is fixed).
My question is, how does increasing the money supply have any effect on people’s demand for money? I mean, people really don’t satisfy their demand for real money balances by borrowing from banks, all they do is cut their spending. So increasing or decreasing money supply shouldn’t really affect people’s demand for real money balances, right?
But I would agree that increasing or decreasing the money supply can affect the demand for real money balances by affecting the price level. But Mankiw assumes the price level to be fixed while deriving the IS curve.
Well, if the money supply is increased and interest rates lowered, money becomes easier to get by - so more people will directly borrow from banks. Maybe most people won’t borrow money for their day-to-day purchases, but some will, and some will use the easier money for larger items - say to finance the purchase of a new house or a car. There will be changes at the margin for sure - and appropriate reductions if the money supply shrinks. (That is not even to speak about some debt-laden countries, where financing by debt became tragically fashionable.)
At the same time, businesses have an easier access to money, so new projects and new businesses will be started. That is bound to have an effect on the price level, too.
In both cases, changing the supply of money will change the supply and demand for goods… so I have no idea why the price level should stay the same. Hope this helps.
Yeah, and there is no reason under normal conditions why people are gonna increase their money balances unless there is a change in the price level. I mailed Mankiw on the same, but he is reluctant on teaching me through e-mails.[:(]
…about that we can only speculate - if the change is small, then the marginal change is also likely to be small. On the other hand, very low interest rates upheld for a long time, especially when coupled with regulatory changes etc., are likely to have a dramatic impact. (“Everybody can afford a house NOW! No down payment necessary!”)
(Oh, and by the way: the interest rate itself is a price. So the price level has changed by definition. )
What you say is possible, but only under very low interest rates. People aren’t really going to add to their money balances by borrowing money at higher interest rates, rather than cutting down on their spending and adding the money they save to their money balances.
And I just realized that the Keynesian system works quite differently from what Austrians see the economy to be like. Mankiw, like a true Keynesian, assumes prices to be sticky in the short run. The ‘price level’ goes up in the Keynesian system only when the economy has attained it’s full productive capacity(or full employment of resources). So the increased money supply, in the Keynesian system, wouldn’t really affect price level until the full employment GDP is attained.
Also, what Mankiw says can be understood when taking the liquidity preference theory into account. The decreased money supply causes interest rates to rise and so people cut down their money balance and deposit it in banks to earn interest.
To understand demand for money, we have to first categorize the ways in which an individual can use money. Let’s say you have $100. There are exactly three things you can do with it:
You can spend it, that is, exchange it for $100 of non-money goods and/or services
You can loan it out
You can stuff it under your mattress
Money which is spent is not a component of the demand for money because you have revealed by trading away the $100 that you preferred to have $100 of non-money goods and services to having the $100. Money which is loaned is not a component of the demand for money since the recipient of the loan has the same three options of how to use the borrowed money. Counting money which has been loaned out would result in double-counting (in a natural money system). Things are more complicated in the expansionary credit system in which we live.
This leaves only money stuffed under the mattress. Money stuffed under the mattress is money which is demanded. This is why it is often referred to as “demand for cash balance” by Austrians. When the demand for money increases, we mean that people prefer to keep larger cash balances. This reduces the amount of money which is “circulating”. That is, the amount of time which has passed since a randomly chosen dollar has changed hands increases. Dollars remain at rest (in the possession of an individual) for longer periods of time. This is called a reduction in the “velocity” of money, in the vocabulary of the Chicago school.
Given a fixed money supply, an increase in the demand for money results in lower prices for non-money goods and services because people have a higher preference for having money to having non-money goods and services. This is a little counter-intuitive because for everything other than money, an increase in demand for it results in a higher money price. But since money is exchanged against non-money goods and services, holding money more dear means to exchange away less money for a given amount of non-money goods and services… prices in money go down when demand for money (cash balances) increases. This causes a general fall in prices.
Conversely, given a fixed money supply, a decrease in the demand for money results in higher prices because people have a higher preference for having non-money goods and services to having money. This causes a general rise in prices.
But why do people prefer to keep more or less money stuffed under the mattress? After all, loaning the money out is always preferable to holding cash because loaning money pays interest. Interest is the price of capital. Entrepreneurs demand capital to fund new ventures. Capitalists (savers) supply capital by saving money. When the supply of capital increases (all things equal), the interest rate decreases. When the supply of capital decreases (all things equal), the interest rate increases.
When the demand for capital decreases (all things equal), the interest rate decreases. When the demand for capital increases (all things equal), the interest rate increases. The interest rate coordinates saving and investment
Loaning money out is less secure than keeping it under the mattress because the borrower might default. When the interest rate decreases, capitalists will be less willing to place their savings at risk as loans. When the interest rate increases, capitalists will be more willing to place their savings at risk as loans.
People stuff the money under their mattress which they do not want to spend or loan out. Spending is determined by the individual’s relative valuation of saving or investing over against non-money goods and services . That is, when there is no non-money good or service which an individual wants more than to save or invest his money, he will cease spending. An individual ceases investing when the market rate of interest is too low for the risk of losing his money on the investment. That is, when there are no investments whose return-on-risk is attractive to the individual, he ceases investing. Whatever cash he chooses not to spend or invest comprises his cash balance. Malinvestment (according to Austrian Business Cycle Theory) contributes to a decrease in demand for non-money goods and services over against cash balances or investment, that is, investing your money or stuffing it under the mattress becomes a more attractive option than spending it when there are not the kinds of goods and services available at the price you would be willing to pay to attract you to spend your money instead. Similarly, an increase in uninsurable risks and other risks in the investment market results in a reduction in the supply of capital for investment because creditors (individuals or banks) become wary of making loans.
When the central bank artificially lowers the interest rate, four things happen:
Demand for capital increases (entrepreneurs want to borrow at the low interest rate)
Supply of capital decreases (capitalists become less willing to make loans at the low interest rate)
Demand for cash balances increases due to malinvestment and increasing economic uncertainty (contributing to a reduction in prices)
Supply of cash increases, since there is no other way to hold interest rates down (contributing to a rise in prices)
Bernankeism/Krugmanism can be summed up by ignoring 1 & 2 and only looking at 3 & 4. The idea is that the central bank can expand the money supply while remaining price-neutral as long as it is doing so to offset a (mysterious) increase in demand for cash balances (deflation). Of course, the Keynesian appeals to “animal spirits” and “collapse in aggregate demand” are just so much voodoo. It’s a way of saying “we don’t know why people are spending less money” in other words.
I think it is a mistake to treat the interest rate as the “price of money”, i.e. a function of the demand for cash balances over against spending or investment. It seems that you are saying this is what Mankiw does. The difficulty in understanding the relationship between interest rates and the general price level comes from the fact that there are three uses of money and a reduction in one use can be the result of an increase in either or both of the alternative uses. In other words, reduced spending can be the result of increased investment or increased demand for cash balances or both. So, reduced spending can be accompanied by lower interest rates (increased investment) or higher interest rates or no change in interest rates, lower general prices (greater demand for cash balances) or higher general prices (reduced demand for cash balances along with increased investment) or no change in general prices. How individuals structure the allocation between cash balances and investment will determine this.
Visit this site for some excellent slideshows illustrating the various relationships I discuss in this post.
Think of this from the perspective of your personal portfolio decisions. You can either keep your savings in the form of cash (which offers no interest) or assets like bonds (which do offer interest).
The opportunity cost of holding part of your savings in cash instead of other assets is the interest you are not earning. If you raise the interest rate, you raise the opportunity cost of holding cash. Because the opportunity cost of money has risen, people will want to hold less cash and more bonds.
Does that make sense?
If so, you make another point in your post I would like to address. You say that people will satisy an increase in the demand for real money balances by spending less. This is not always the case. For example, let’s say I save $1,000 with $500 in bonds and $500 in cash. If I want to increase my cash holdings, couldn’t I just cash cash out some bonds (say $100 worth) and add it to my cash balances (to get a new total of $600 in cash and $400 in bonds)? Doing so would not impact consumption at all, only my portfolio balance.
You are right that a person could reduce their spending to increase cash balances. However, this is not typically how IS-LM is set up in undergraduate courses. Instead, the saving-consumption decision is seperated from the portfolio decision.
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