Chapter 28:
Money, Interest Rates,
and Economic Activity
Copyright © 2014 Pearson Canada Inc.
Chapter Outline/Learning Objectives
Section
Learning Objectives
After studying this chapter, you will be able to
28.1 Understanding Bonds 1. explain why the price of a bond is inversely related to the
market interest rate.
28.2 The Theory of Money 2. describe how the demand for money depends on the
Demand
interest rate, the price level, and real GDP.
28.3 Monetary
Equilibrium and
National Income
3. explain how monetary equilibrium determines the
interest rate in the short run.
28.4 The Strength of
Monetary Forces
5. understand the difference between the short-run and
long-run effects of monetary policy.
4. describe the transmission mechanism of monetary policy.
6. describe under what conditions monetary policy is most
effective in the short run.
Copyright © 2014 Pearson Canada Inc.
Chapter 28, Slide 2
28.1 Understanding Bonds
For simplicity, we assume that people have two types of financial
assets:
• money (earns no interest)
• bonds (earn interest)
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www.myeconlab.com
Copyright © 2014 Pearson Canada Inc.
For readers interested in learning more about the stock market,
the market in which equities are traded, look for A Beginner's
Guide to the Stock Market in the Additional Topics section of this
book's MyEconLab.
Chapter 28, Slide 3
28.2 The Theory of Money Demand
Three Reasons for Holding Money
The amount of money that everyone wishes to hold is the demand
for money.
The opportunity cost of holding money is the interest that could
have been earned if the money had been used to purchase bonds.
There are three reasons for holding money:
• the transactions motive
• the precautionary motive
• the speculative motive
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Chapter 28, Slide 4
The Determinants of Money Demanded
We focus on three variables:
• real GDP (+)
• the price level (+)
• the interest rate (-)
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Chapter 28, Slide 5
Fig. 28-1
Money Demand as a Function of the
Interest Rate, Real GDP, and the Price Level
This money demand (MD)
curve is sometimes called
the liquidity preference
function.
Changes in Y or P cause
the MD curve to shift.
Changes in the interest rate
cause movements along the
MD curve.
Copyright © 2014 Pearson Canada Inc.
Chapter 28, Slide 6
Money Demand—Summing Up
- + +
MD = MD (i, Y, P)
Remember there are two assets—bonds and money.
The decision to hold money is the same as the decision not to hold
bonds.
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Chapter 28, Slide 7
28.3 Monetary Equilibrium and National Income
Monetary Equilibrium
Fig. 28-2
Monetary Equilibrium
Monetary equilibrium
occurs when the quantity
of money demanded equals
the quantity of money
supplied:
 equilibrium interest rate
Copyright © 2014 Pearson Canada Inc.
Chapter 28, Slide 8
The Money Transmission Mechanism
Monetary transmission mechanism:
• connects changes in MD and/or MS with aggregate demand
Three stages:
1. ΔMD or ΔMS  Δ in equilibrium interest rate
2. Δi  Δ in desired investment expenditure
3. ΔID  Δ in AD
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Chapter 28, Slide 9
Fig. 28-3
Changes in the Equilibrium Interest Rate
Stage 1. Shifts in the MS or MD curves cause the equilibrium interest
rate to change.
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Chapter 28, Slide 10
Fig. 28-4
The Effects of Changes in the Money Supply
on Desired Investment Expenditure
Stage 2. Changes in the equilibrium interest rate lead to changes
in desired investment.
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Chapter 28, Slide 11
Fig. 28-5
The Effects of Changes in the Money Supply
on Aggregate Demand
Stage 3. Changes in
desired investment
lead to a shift in the
AE function, and thus
a shift in the AD curve.
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Chapter 28, Slide 12
Fig. 28-6
Summary of the Monetary Transmission Mechanism
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Chapter 28, Slide 13
The Slope of the AD Curve
In Chapter 23, there were two reasons for the negative slope of the
AD curve:
• ΔP leads to Δwealth
• ΔP leads to ΔNX
We can now add a third reason—the effect of interest rates.
A rise in P leads to:
• an increase in money demand
• higher interest rate
 this reduces desired investment
Copyright © 2014 Pearson Canada Inc.
Chapter 28, Slide 14
MyEconLab
www.myeconlab.com
Copyright © 2014 Pearson Canada Inc.
For more details about how changes in the price level influence
money demand, interest rates, and investment, and help explain
the negative slope of the AD curve, look for Interest Rates and
the Slope of the AD Curve in the Additional Topics section of this
book's MyEconLab.
Chapter 28, Slide 15
28.1 The Strength of Monetary Forces
Long-Run Neutrality of Money
A shift in the AD curve will lead to different effects in the short run
than in the long run.
In the long run, output eventually returns to Y*.
Money neutrality is the idea that changes in the money supply do not
have real effects on the economy.
Copyright © 2014 Pearson Canada Inc.
Chapter 28, Slide 16
Fig. 28-8
The Long-Run Neutrality of Money
What does money neutrality
look like?
• MD shifts up as P and Y
adjust to new long-run
equilibrium
• interest rate returns to
its initial level
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Chapter 28, Slide 17
Long-Run Neutrality of Money
The proposition of long-run money neutrality is debatable.
Hysteresis: the growth rate of Y* may be affected by the
short run path of real GDP.
Why?
• A change in the money supply, through its effect on the
interest rate, can affect investment and technological change.
• In a long period of unemployment workers can lose human
capital, this can affect Y* and its growth rate.
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Chapter 28, Slide 18
Money and Inflation
Fig. 28-9
Inflation and Money Growth Across Many
Countries, 1978–2010
Across many countries over long periods of time, the rate of inflation
and the growth rate of the money supply are highly correlated.
Copyright © 2014 Pearson Canada Inc.
Chapter 28, Slide 19