Welcome back, my fellow Earth economists! Last lecture ended with a puzzle. You remember this graph of the breakdown of the relationship between GPP and broad money since the start of the Great Recession. We need to understand demand for money, supply for money, and we will develop a model for the money market. At the end of this lecture, you will have the tools to understand this breakdown. Real money demand consists of three components based on precautionary money demand, transaction money demand, and speculative money demand. Precautionary money demand is exogenous, and reflects our wish to hold more cash in risky times in order to be able to act and move quickly during emergencies. It is not easy to find examples of precautionary money demand at the planetary level, since most data are annual only, while emergencies typically are short-term events. So in today's data exercise, we will look at central bank data for instances of exogenous shocks in money demand. This equation for the transaction demand of money is straightforward. If economic activity increases, we need more money to pay. Therefore, we assume a positive relationship between the real money balances and GPP. The final component is speculative demand. Speculative money demand is negatively related to the interest rate. One obvious reason for a negative relationship would be the opportunity costs of holding cash money. The opportunity costs are the interest that you do not get when money is in your pocket and not on your account. At higher rates of interest, people will put their money on saving accounts, rather than cash. And this explains a negative relationship between money demand and interest rate that is not speculative. For demand to be speculative, we need to have investors in bonds. Bonds essentially are special loan contracts. The issuer sells the bond to the holder, and has to pay interest at fixed intervals, and repay the principal at the end of the pre-specified date. A special bond is a perpetuity, that is, a bond with no maturity, so that the borrower only pays interest, but never repays the principal. The reason to study a perpetuity is that the calculations are easy. Now consider what happens with a perpetuity bond that pays 100 every year. How much would you value this bond? This, of course, depends on the interest rate. If the interest rate is 10%, the perpetuity is worth 1,000, because if you put 1,000 on the bank at 10%, you also get 100 every year. Now, what if the interest rate were 5%? Now the value is 2,000. So what would you do if the interest rate is 10% and you expect that it will decrease? You would buy the perpetuity for 1,000, and sell it later at a profit, and realize the capital gain. This is where speculation meets money demand. Since increasing your holding of bonds reduces your holding of money. But what will happen if the interest rate today is very low and you expect it to increase in the near future? Let's think about 1% interest. The answer is 10,000 because 1% is 100 again. So the perpetuity is expensive. Most investors will expect a future increase in the interest, and thus a reduction in the yield. Now, in order to avoid a capital loss, they will not buy the expensive perpetuity, and stick to cash. And the reduction of the interest rate will make that cash preference only stronger. In order to see what this means, we must first develop our model of the money market. Our model for the money market is straightforward. We start with the definition of real money demand. Money demand increases if precautionary money demand exogenously increases, and when GPP increases. But it decreases if the interest rate increases. The equilibrium condition is that real money demand equals real money supply. Now pause the video to read the diagram carefully. In this diagram, we have interest on the vertical axis, and real money supply and real money demand on the horizontal axis. The vertical line is the real money supply. Professor Peter, why does the money demand curve slope downwards? At lower levels of interest, we want to hold cash rather than bonds. We want to be liquid, and the opportunity costs of holding cash are low. But why then is the real money supply vertical? Well, this represents that the money supply is given by the central bank, and it does not depend on the interest rate. It will influence the money market rate, but the rate does not influence the money supply. So equilibrium is where money supply equals money demand. Is this a stable equilibrium? At high interest levels, demand is smaller than supply, and this drives down interest. At low interest levels, demand exceeds supply, and this drives up the price of money. So it is a stable equilibrium. Now let's see what happens if the central bank enlarges the money supply. The money supply curve shifts to the right, the interest rate decreases. This is a well-known mechanism by which central banks can reduce the interest rate, but there are limits to this policy. At some point, further increases of the money supply cannot further reduce the interest rate, simply because the interest rate has reached a zero lower bound. This is the liquidity trap, where monetary policy is ineffective. Now, for long, economists have argued that the liquidity trap did not exist. It was "just one of Keynes' famous debating tricks to prove his theory". Or they claim that it was an oddity of the 1930s. Now take a look at this graph of the real world interest rate. Rates are historically low. What do you think, will it decrease further, stay the same, or increase in the next five years? There are no wrong answers to this question, but the answers have different implications. If you answered "decrease", then you would probably think that the liquidity trap is not a serious issue. If your answer is "more or less the same", then the Earth economy could continue to be in the liquidity trap. And if you answered increase, the Earth economy clearly is in a liquidity trap, but you also think that Earth may escape soon. Now, all predictions are difficult, especially when it concerns the future (-:
