Changes in the Money Supply and the Interest Rate in the Long Run

In the short run, an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate. In the long run, however, changes in the money supply don’t affect the interest rate.

Figure 15-12 shows why. It shows the money supply curve and the money demand curve before and after the Fed increases the money supply. We assume that the economy is initially at E1, in long-run macroeconomic equilibrium at potential output, and with money supply . The initial equilibrium interest rate, determined by the intersection of the money demand curve MD1 and the money supply curve MS1, is r1.

The Long-Run Determination of the Interest Rate In the short run, an increase in the money supply from to pushes the interest rate down from r1 to r2 and the economy moves to E2, a short-run equilibrium. In the long run, however, the aggregate price level rises in proportion to the increase in the money supply, leading to an increase in money demand at any given interest rate in proportion to the increase in the aggregate price level, as shown by the shift from MD1 to MD2. The result is that the quantity of money demanded at any given interest rate rises by the same amount as the quantity of money supplied. The economy moves to long-run equilibrium at E3 and the interest rate returns to r1.

Now suppose the money supply increases from to . In the short run, the economy moves from E1 to E2 and the interest rate falls from r1 to r2. Over time, however, the aggregate price level rises, and this raises money demand, shifting the money demand curve rightward from MD1 to MD2. The economy moves to a new long-run equilibrium at E3, and the interest rate rises to its original level at r1.

And it turns out that the long-run equilibrium interest rate is the original interest rate, r1. We know this for two reasons. First, due to monetary neutrality, in the long run the aggregate price level rises by the same proportion as the money supply; so if the money supply rises by, say, 50%, the price level will also rise by 50%. Second, the demand for money is, other things equal, proportional to the aggregate price level.

So a 50% increase in the money supply raises the aggregate price level by 50%, which increases the quantity of money demanded at any given interest rate by 50%. As a result, the quantity of money demanded at the initial interest rate, r1, rises exactly as much as the money supply—so that r1 is still the equilibrium interest rate. In the long run, then, changes in the money supply do not affect the interest rate.

!worldview! ECONOMICS in Action: International Evidence of Monetary Neutrality

International Evidence of Monetary Neutrality

These days monetary policy is quite similar among wealthy countries. Each major nation (or, in the case of the euro, the euro area) has a central bank that is insulated from political pressure. All of these central banks try to keep the aggregate price level roughly stable, which usually means inflation of at most 2% to 3% per year.

The Long-Run Relationship Between Money and Inflation Source: Federal Reserve Bank of St. Louis.

But if we look at a longer period and a wider group of countries, we see large differences in the growth of the money supply. Between 1970 and the present, the money supply rose only a few percent per year in some countries, such as Switzerland and the United States, but rose much more rapidly in some poorer countries, such as South Africa. These differences allow us to see whether it is really true that increases in the money supply lead, in the long run, to equal percent rises in the aggregate price level.

Figure 15-13 shows the annual percentage increases in the money supply and average annual increases in the aggregate price level—that is, the average rate of inflation—for a sample of countries during the period 1981–2013, with each point representing a country. If the relationship between increases in the money supply and changes in the aggregate price level were exact, the points would lie precisely on a 45-degree line.

In fact, the relationship isn’t exact, because other factors besides money affect the aggregate price level. But the scatter of points clearly lies close to a 45-degree line, showing a more or less proportional relationship between money and the aggregate price level. That is, the data support the concept of monetary neutrality in the long run.

Quick Review

  • According to the concept of monetary neutrality, changes in the money supply do not affect real GDP, they only affect the aggregate price level. Economists believe that money is neutral in the long run.

  • In the long run, the equilibrium interest rate in the economy is unaffected by changes in the money supply.

15-4

  1. Question 15.8

    Assume the central bank increases the quantity of money by 25%, even though the economy is initially in both short-run and long-run macroeconomic equilibrium. Describe the effects, in the short run and in the long run (giving numbers where possible), on the following.

    1. Aggregate output

    2. Aggregate price level

    3. Interest rate

  2. Question 15.9

    Why does monetary policy affect the economy in the short run but not in the long run?

Solutions appear at back of book.

PIMCO Bets on Cheap Money

Pacific Investment Management Company, generally known as PIMCO, is one of the world’s largest investment companies. Among other things, it runs PIMCO Total Return, the world’s largest mutual fund. Bill Gross, who headed PIMCO from 1971 until 2014, was legendary for his ability to predict trends in financial markets, especially bond markets, where PIMCO does much of its investing.

In the fall of 2009, Gross decided to put more of PIMCO’s assets into long-term U.S. government bonds. This amounted to a bet that long-term interest rates would fall. This bet was especially interesting because it was the opposite of the bet many other investors were making. For example, in November 2009 the investment bank Morgan Stanley told its clients to expect a sharp rise in long-term interest rates.

What lay behind PIMCO’s bet? Gross explained the firm’s thinking in his September 2009 commentary. He suggested that unemployment was likely to stay high and inflation low. “Global policy rates,” he asserted—meaning the federal funds rate and its equivalents in Europe and elsewhere—“will remain low for extended periods of time.”

PIMCO’s view was in sharp contrast to those of other investors: Morgan Stanley expected long-term rates to rise in part because it expected the Fed to raise the federal funds rate in 2010.

Who was right? PIMCO, mostly. As Figure 15-14 shows, the federal funds rate stayed near zero, and long-term interest rates fell through much of 2010, although they rose somewhat very late in the year as investors became somewhat more optimistic about economic recovery. Morgan Stanley, which had bet on rising rates, actually apologized to investors for getting it so wrong.

The Federal Funds Rate and Long-Term Interest Rates, 2009–2011 Source: Federal Reserve Bank of St. Louis.

Bill Gross’s foresight, however, was a lot less accurate in 2011. Anticipating a significantly stronger U.S. economy by mid-2011 that would result in inflation, Gross bet heavily against U.S. government bonds early that year. But this time he was wrong, as weak growth continued. By late summer 2011, Gross realized his mistake as U.S. bonds rose in value and the value of his funds sank. He admitted to the Wall Street Journal that he had “lost sleep” over his bet, and called it a “mistake.” It was a mistake from which he never fully recovered. Most observers agreed that the losses PIMCO suffered from Gross’s bad bet in 2011 played a major rule in his departure in 2014.

QUESTIONS FOR THOUGHT

Question 15.10

Why did PIMCO’s view that unemployment would stay high and inflation low lead to a forecast that policy interest rates would remain low for an extended period?

Question 15.11

Why would low policy rates suggest low long-term interest rates?

Question 15.12

What might have caused long-term interest rates to rise in late 2010, even though the federal funds rate was still zero?