If long-term interest rates are 8% and short-term rates are 3%, the market expects. Short-term rates to rise If the economy is at potential output and the Fed increases the money supply, in.
- How Changes In The Money Supply Affect Real Interest Rates
- Money Supply Real Interest Rate Definition
Reading: AB, chapter 7, section 4.
Real money demand and the real money supply as functions of the real interest rate are illustrated in the above graph. Real money demand is graphed holding fixed real income and expected inflation. The real money supply is equal to the nominal amount of M1, denoted M0, divided by the fixed aggregate price level, P0. It is assumed that the Fed does not alter the money supply based on the valued of the real interest rate. Therefore, the real money supply function is a vertical line in the graph with the real interest rate on the vertical axis and real money balances on the horizontal axis.
Notice that real money demand and real money supply intersect when the real interest rate is 5%. This is the value of the real interest that equates money demand with the money supply and establishes equilibrium in the money market. When the money market is in equilibrium there are no economic forces acting on the economy to alter the real interest rate.
If the real interest rate were 8% then the demand for real balances would be greater than the fixed supply of real balances (as illustrated above). In this case we say there is an excess supply of money in the money market. Practically, what this means is that individuals are holding more money than they would like given the high real interest rate. Accordingly, individuals will attempt to rebalance their portfilios; i.e. they will try to get rid of money by buying bonds (our generic non-money asset). In doing so the demand for bonds increases and so the price of bonds increases. Because bond prices are inversely related to the interest rate on bonds, the increased price of bonds lowers the real return on bonds (holding expected inflation fixed). Therefore, the excess supply of money at 8% (disequilibrium in the money market) leads to economic forces that act to lower the real interest rate. These forces cease to operate when the real interest falls to 5% where the demand for real balances is equal to the supply of real balances.
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Your question highlights a common misconception about how the Fed conducts monetary policy. For a period of time, the Fed did in fact implement monetary policy by controlling the monetary aggregates (the quantity of money). However, developments in the financial services industry, changes in the relationship between the money supply and the economy, as well as changes in views on monetary policy, eventually led to the Fed reverting back to implementing monetary policy through changes in interest rates (the price of money). 1
What are the monetary aggregates, and why does the Fed still care about them?
Though the Fed no longer implements changes in monetary policy by controlling the growth rate of the money supply, the monetary aggregates are still monitored by economists as an indicator of future economic activity. One measure of the money supply, real or inflation-adjusted M2, is classified as a leading economic indicator. In order from most narrow to most broad, the three nominal monetary aggregates published weekly by the Federal Reserve Board in the H.6 Release,Money Stock Measures are: 2
- M1: The most liquid forms of money including currency in the hands of the public, travelers checks, demand deposits, and other deposits against which checks can be written.
- M2: M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.
- M3: M2, plus large-denomination ($100,000 or more) time deposits, balances in institutional money market mutual funds, repurchase liabilities issued by depository institutions, and Eurodollars held by U.S. residents at foreign branches of U.S. banks and at all banks in the United Kingdom and Canada.
When the money supply grows, consumers and businesses have relatively more money in their hands with which to purchase goods and services. Therefore, in theory, faster money supply growth should be associated with faster economic growth after a short lag of perhaps two or three quarters. However, many important changes in how financial assets are held by the public have changed over time and the relationship between money supply growth rates and the economy has deteriorated.
Why doesn’t the Fed still conduct monetary policy by controlling the size of the monetary aggregates?
The Fed’s Purposes and Functions (2005) publication describes the change that has occurred over time in the relationship between monetary aggregates and Gross Domestic Product (GDP):
“[T]he relation between the growth in money and the growth in nominal GDP, known as ‘velocity,’ 3 can vary, often unpredictably, and this uncertainty can add to difficulties in using monetary aggregates as a guide to policy. Indeed, in the United States and many other countries with advanced financial systems over recent decades, considerable slippage and greater complexity in the relationship between money and GDP have made it more difficult to use monetary aggregates as guides to policy. In addition, the narrow and broader aggregates often give very different signals about the need to adjust policy. Accordingly, monetary aggregates have taken on less importance in policy making over time.”
Historical growth of money and the economy
Below is a simple comparison of the growth rates of the real M2 and real growth rates of the U.S. economy; the gray bars represent periods of recession as defined by the National Bureau of Economic Research (NBER). This graph illustrates how the relationship between money growth and the economy has changed over time.
The chart displays the “before” period, when monetary policy focused on the monetary aggregates, which ended in the mid-1980s, as well as the “after” period, when the importance of monetary aggregates as indicators of future economic performance diminished. From 1960 until the mid-1980s, each recession is preceded by a sharp decline in the growth rate of real M2. However, in the period after the mid-1980s, the correlation between the growth rate of real M2 and the economy is much weaker.
Changing financial services
One of the key factors behind the change in the relationship between money and the economy has been the significant changes in the financial services industry over the years. New banking laws and the development of new types of financial assets and products have blurred the distinctions between balances counted in the monetary aggregates and other types of financial assets. In short, these developments brought about significant changes in the way people hold money and other types of financial assets. For example, monitoring the monetary aggregates for clues to future economic performance became much more difficult once savers could frequently and cheaply shift between balances counted in M2 (like money market mutual fund shares) and other financial balances that are not counted in the money aggregates (such as mutual fund shares). Moreover, even the relationship between the aggregates changed since the early eighties.
'Depositors moved funds from savings accounts—which are included in M2 but not in M1—into [Negotiable Order of Withdrawal] accounts, which are part of M1. As a result, M1 growth exceeded the Fed's target range in 1982, even though the economy experienced its worst recession in decades. The Fed de-emphasized M1 as a guide for monetary policy in late 1982, and it stopped announcing growth ranges for M1 in 1987.
By the early 1990s, the relationship between M2 growth and the performance of the economy also had weakened. Interest rates were at the lowest levels in more than three decades, prompting some savers to move funds out of the savings and time deposits that are part of M2 into stock and bond mutual funds, which are not included in any of the money supply measures.'4
Broken relationship between money and the economy
In July 1993, Federal Reserve Chairman Alan Greenspan testified before Congress that the Fed would no longer use the monetary aggregates to guide FOMC policy—in large part because the long-run relationship between M2 and the economy had broken down.
'[I]f the historical relationships between M2 and nominal income had remained intact, the behavior of M2 in recent years would have been consistent with an economy in severe contraction.’ Chairman Greenspan added, ‘The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place.” 5
Since the Chairman’s announcement in 1993, the relationship between the growth rate of M2 and real GDP has remained weak.
Today, the Fed targets the price of reserves—the federal funds interest rate—to implement monetary policy. For more information on how the Fed sets monetary policy today, see the Federal Reserve Bank of San Francisco’s publication,U.S. Monetary Policy: An Introduction.
Endnotes
1. For a historical account of changes in the Fed’s approach to monetary policy over recent decades, see Dr. Econ’s January 2003 posting.
How Changes In The Money Supply Affect Real Interest Rates
2.“The Money Supply,”Fedpoint, Federal Reserve Bank of New York, January 2003.
3.Velocity of money is commonly defined as the ratio of nominal gross domestic product to money stock, or the rate at which money balances turn over (or change hands) in a period of time relative to expenditures on goods and services. A larger velocity means that a given quantity of money is associated with a greater dollar volume of transactions.
4. “The Money Supply,”Fedpoint, Federal Reserve Bank of New York, January 2003.
5. Ibid.
Additional Reading
To see how the Federal Reserve watches monetary trends, see the Federal Reserve of St. Louis’ Monetary Trendspublication.
Money Supply Real Interest Rate Definition
Dr. Econ receives a lot of questions about the money supply. For previous discussions, please see: