Openmarket Operations And Shortterm Interest Rates

A change in the Ml money supply affects the short-term rate of interest when there is no change in the private sector's demand for money. There are numerous reasons why the private sector holds money balances; these reasons can be categorized into types of demand, as follows: (1) a transaction demand, since money is needed to purchase goods and services, to pay employees, etc.; (2) a precautionary demand, since money may be held to meet emergency and unforeseen needs that may arise; (3) a portfolio (asset) demand, since some money balances are held in the expectation of opportunities in the financial markets. When there is a given demand for money, an increase in the M1 money supply lowers the short-term nominal rate of interest, ceteris paribus.

EXAMPLE 10.4. L' in Fig. 10-1 depicts the demand for money. The amount of money demand is inversely related to the rate of interest since the holder of money forgoes a higher interest return from an alternative financial asset.

EXAMPLE 10.4. L' in Fig. 10-1 depicts the demand for money. The amount of money demand is inversely related to the rate of interest since the holder of money forgoes a higher interest return from an alternative financial asset.

Quantity of money

Quantity of money

When the Federal Reserve purchases government securities in the open market, bank reserves increase as does the Ml money supply. Thus, money supply curve S' in Fig. 10-1 shifts rightward to S" as the M1 money supply increases and the short-term rate of interest falls from i„ to /1.

The downward pressure on short-term interest rates due to an increase in the money supply is also evident when we consider the effect that an increase in bank reserves has upon bank lending. In purchasing government securities and supplying more reserves to the banking system, the Federal Reserve increases the supply of excess reserves in the fed funds market. An increased supply of excess reserves puts downward pressure on the fed funds rate. Since lending is more profitable than selling excess reserves to other banks, many banks increase lending when additional reserves flow into the banking system. Banks can encourage more borrowers to apply for bank loans by lowering their lending rates.


Consumer spending on large-ticketed items such as condominiums, houses, and cars is interest-sensitive since individuals are likely to take out loans to pay for major purchases. Business investment—purchases of new buildings and new equipment—is also interest-sensitive; many of these purchases, too, are financed by borrowing. Thus, as depicted in Fig. 10-2, a Federal Reserve increase in the money supply should lower the rate of interest, increase interest-sensitive spending, and result in a higher level of spending and gross domestic product.

f M —>1 i —»| total spending —»f gross domestic product Fig. 10-2


The importance of money as a medium of exchange is formalized in the equation of exchange MV = GDP, where M is the Ml money supply, V is the velocity of money (the average number of times a unit of money is used during a one-year period to purchase final goods and services), and GDP is the nominal value of final domestic output of goods and services. The nominal value of GDP can also be expressed as PQ in which P is a weighted average of the prices of final output and Q is the quantity (units) of final output. Whether it is presented as MV = GDP or MV = PQ, the equation of exchange is an identity and should be written MV = PQ. (The three bars indicate that the equation is a tautology— it is true by definition.)

EXAMPLE 10.5. Suppose the money supply is $312 and final output consists of the following sector spending: consumption, $1080; investment, $240; government spending, $366; and net exports, $7.

Nominal GDP must equal $1693, which is the sum of sector spending. Since the nominal money supply is $312, the velocity of money must be 5.426 since

and the equation of exchange would appear as


Quantity theorists have used the equation of exchange to explain price movements over time. In the rigid version of the quantity theory, V and Q are assumed constant; increases in the money supply, therefore, result in proportional increases in the price level (see Problem 10.21). The flexible version of the quantity theory includes the possibility of changes in V and/or Q over time. In a growing economy, real output (Q) usually increases from year to year. When velocity changes are predictable, growth in nominal GDP is closely associated with increases in the supply of money (Example 10.6). Since nominal GDP equals PQ, quantity theorists suggest that a relatively stable price level is achieved when growth of the money supply is closely tied to growth in the economy's ability to expand output. The flexible version of the quantity theory therefore suggests that money is an important determinant not only of the price level but of spending levels as well.

EXAMPLE 10.6. Suppose that the money supply is $400, V is 4, and nominal GDP is $1600. A quantity theorist would predict that nominal GDP would increase to $2016 over a five-year period should the Federal Reserve expand the money supply 20% over this period and should the velocity rise to 4.2 by the fifth year.

GDP = (M + A M)V GDP = {$400 + [$400(0.20)]} 4.2 GDP = ($400 + $80)4.2 GDP = $2016

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