The textbook answer, which Bryan gave but rejected, is that interest rates go up, the demand for money falls, and the fall in the demand for money acts like an increase in the supply of money–nominal GDP goes up.
Bryan questioned whether money demand responds to small changes in interest rates. Inelastic money demand (the opposite of a liquidity trap, which would be super-elastic money demand), is a weird case to think about, because it makes the Fed unable to determine the money supply. Suppose that the Fed wants to raise (lower) the money supply. Under Bryan’s assumption, the only way to increase (reduce) money demand is to make interest rates fall (rise) by a huge amount. I think that the “inelastic money demand function” is neither theoretically nor empirically interesting.
Hold on, Arnold. A textbook money demand function depends on both interest rates and INCOME. If the interest-elasticity of money demand is zero, the effect of a monetary expansion is to raise nominal income until people are willing to hold the amount of money that exists. Just picture shifting a vertical LM curve to the right. The Fed can raise the money supply as much as it likes – zero interest-elasticity is no obstacle.
Not empirically interesting? I beg to differ. I doubt one non- economist in twenty adjusts his money holdings when the interest rate changes. But lots of people adjust their money holdings when their income goes up.
If you took a look at my financial history for the last twenty years, for example, I’d be amazed if there were any connection between how much money I held and what interest rates were. But there is a clear positive relationship between how much money I held and my income: When I was a poor student, I averaged about $20 in my wallet. Now it’s usually ten times higher.
Hmm… I hope no local muggers read this blog!
READER COMMENTS
Nathan Smith
Jun 20 2006 at 10:46am
Money is not the same as cash. You might not change the amount of money that you hold in your wallet based on interest rates, but they might affect your decision to take out student loans, or to refinance your home, and those decisions will influence how much money is in your checking account, which is also part of the M1 money supply.
Mark Horn
Jun 20 2006 at 10:50am
My willingness to buy a large asset in which to hold money (e.g. my house) increases and falls with the interest rate. Similarly, my willingness to hold money in a bond or a money market increases and falls with the interest rate. Certainly I don’t move my money with every single interest rate change. But when the interest rates pass a threshold, I make changes to my holdings.
This seems (to me) like a very common mentality. Why aren’t the above examples of what Bryan says rarely happens?
dWj
Jun 21 2006 at 8:51pm
Most actual cash, to my understanding, is held by banks, which certainly respond to interest rate changes. As for M2 sorts of things, plenty of non-economists are more willing to borrow money when interest rates go down, and try to pay off debt when it goes up; I don’t know that spending of balances by individuals responds in quite the same way, but I think by businesses it does something similar. I don’t see that what the macroeconomics textbooks propose is so micro-counterintuitive as you claim.
Lauren
Jun 25 2006 at 6:13am
dWj wrote:
I agree with almost everything you wrote, but I’m not so sure about this one claim. Most actual cash is very much in circulation, documentably outside of banks. Who the other large cash-holders are has been an interesting question since the 1970s. Cash is certainly not typically used in large quantities for the daily transactions of the blog-contributing component of the population!
Large chunks of U.S. cash are held abroad, where they are sometimes used in large quantities for black market transactions and as stores of value in countries whose own currencies are inflationary or inconvertible. (As an extreme recent example, consider the enormous cash hordes found in Iraqi safeholds after the toppling of Saddam Hussein.) Large chunks are used for illicit transactions right here in the United States.
To get a handle on how large these other uses are, divide the quantity of cash dollars (or whatever measure of U.S. money you are looking at, perhaps after subtracting the measured cash reserves held by banks) by the U.S. population. The size of the average cash balances held individually will knock your socks off. Your next question will be: since you and no one you know is holding cash balances like that, who is?!
Measuring the interest sensitivity of some of these other large money holders is tricky because the holders are intentionally hiding their cash balances, transactions, and bank accounts; and they are often overseas. I’d have to guess, though, that the large cash holders are fairly savvy and move the money around in international markets and black markets quite a bit. International interest rates are certainly responsive to each other. Do black market interest rates affect legitimate interest rates? I’d bet they do (and vice versa).
Anyone got a link? Economists used to consider the characteristics of who the large cash-holders might be routinely in the 1970s and 1980s, when U.S. double-digit inflation was on our minds. (“Who is holding cash ‘at the margin’?” is the way economists ask the question, in tech terms.)
The marginal cash-holder is not the banking system. Banks lose money when they hold cash instead of lending it out at interest–as you point out. Banks try to keep their cash holdings as small as possible as a consequence. They keep minimal cash holdings to satisfy the requirements based on their expectations of their bank depositors’ daily requests for cash, and for legal requirements to hold cash reserves.
The marginal cash-holder is also not Grandma–maybe hoarding cash under her mattress. And, it’s probably not ordinary folks like you or me going to the bank every few weeks for a little cash in their daily transactions.
The international integration of cash holdings and credit markets is fundamental to economics, but is often forgotten by U.S. writers when discussing the dollars they use in their daily lives.
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