9.2 The Modem Quantity Theory

bonds on the open market, but to buy these bonds it must induce us to sell them by bidding up their price. This rise in the price of bonds means that the interest coupon on a bond is now a lower percentage payment that is, the interest rate falls. Similarly, if the central bank wishes to decrease the money supply, it sells government bonds on the open market (the central bank has a large portfolio of government bonds it can draw on for this purpose). To sell bonds it must make them attractive to potential buyers by offering a higher interest rate, accomplished by selling the bonds at a lower price.
The main result here is that by changing the money supply, the central bank also changes the interest rate by affecting the price of bonds: an increase in the money supply lowers the interest rate by bidding up the price of bonds, and a decrease in the money supply raises the interest rate by lowering the price of bonds. This relationship explains why the role of the central bank is often explained in terms of its interest-rate policy rather than in terms of its money-supply policy. The one is a mirror image of the other.
This explanation of the determination of the interest rate focuses on what is happening in the bond market. For convenience, economists often view the determination of the interest rate in another, equivalent way by interpreting the interest rate as the ''price" of money and by looking at what is happening to the supply of and demand for money. The rationale for this approach is that individuals are thought to hold wealth in one of only two forms, money and bonds, so an increase in the demand for one implies a decrease in the demand for the other.
Consequently, because buying bonds increases the supply of money, it should lower its "price," the interest rate. An increase in the demand for money, caused, for example, by an increase in the level of income, should increase its "price," so the interest rate should rise. In terms of the bond market, the increased demand for money means people want to sell bonds to get cash. This selling lowers the price of bonds, raising the interest rate. This topic could be explicated by means of some graphical curve-shifting, but it is an instance in which the common sense of supply-and-demand forces is all that is necessary; the curves themselves are superfluous. Don't confuse supply and demand for money with the "money market," which refers to the market for short-term bonds.
10.4
The Transmission Mechanism
Introducing the interest rate means that we must change the story we had told earlier about how monetary policy affects economic activity. In our earlier story the explanation of the modem quantity theory an increase in the money supply caused people to find themselves holding more of their wealth in the form of money than they wished to hold in the form of money. We assumed that they spent these excess money holdings to try to get rid of them. Now we note that increasing the money supply causes the interest rate to fall, which (as described in our discussion of crowding out in chapter 7) stimulates spending by consumers, firms, and local governments. The increase in spending leads to the familiar Keynesian multiplier process, moving the economy to a higher level of income, as illustrated in figure 10.1.

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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