Macroeconomics

Sixth Canadian Edition

Chapter 12
A Monetary Intertemporal
Model: Money, Banking,
Prices, and Monetary Policy

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Chapter 12 Topics
• What is money?
• Monetary Intertemporal Model
• Real and nominal interest rates.
• Demand for money – banks and alternative means of
payment.
• Neutrality of money
• Zero lower bound and unconventional monetary policy.
• Corridor Systems and Floor Systems.

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What is Money?
• Medium of exchange
• Store of value
• Unit of account

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The Inflation Rate

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The Fisher Relation

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The Approximate Fisher Relation

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Figure 12.1
The Fisher Relation

The figure shows a scatter plot of the short-term nominal interest rate vs. the inflation rate, for the period
1962–2019. There is a clear positive correlation.

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Figure 12.2
The Measured Real Interest Rate

The real interest rate has been highly variable and has been persistently high and low. Of note is the long
decline in the real interest rate from the early 1980s until 2019.

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Banks and Alternative Means of Payment
(1 of 2)

• Assume all goods must be purchased with currency or

credit cards.
• “Credit cards” can be assumed to stand in, more broadly,
for debt cards and checks, for example – all alternative
means of payment supplied by the financial system.
• Goods purchased at price P, no matter what means of
payment is used.

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Banks and Alternative Means of Payment
(2 of 2)

• Using a credit card costs q per unit of goods purchased.

• Credit supply (by banks) is given by Xs(q), which is
increasing in q.
• Supplying credit card services is costly for banks.

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Figure 12.3
The Supply Curve for Credit Card Services

The supply curve is upward-sloping as the profitability of extending credit balances increases as q
increases, so banks increase quantity supplied.

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Demand for Credit Card Services
• Quantity of goods purchased with credit card services:
Xd (q)
• Goods purchased with currency: Y−Xd (q)
• If P(1 + R) > P(1+ q) then all goods are purchased with
credit cards.
• If P(1 + R) < P(1+ q), then all goods are purchased with
currency.

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Figure 12.4
Equilibrium in the Market for Credit Card Services

The demand curve for credit balances is horizontal at the price q = R, the equilibrium price of credit card
services is q = R, and the quantity is X*.

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Figure 12.5
The Effect of an Increase in the Nominal Interest Rate on the
Market for Credit Card Services

An increase in the nominal interest rate from R1 to R2 shifts the demand curve for credit balances up from
X!" to X!#. The equilibrium price of credit card balances increases from R1 to R2 and the equilibrium quantity
increases from X"∗ to X#∗.

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Demand for Money (1 of 2)

• Here, X*(R) is the equilibrium quantity of credit card

services (decreasing function of R). Therefore, more
simply,

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Demand for Money (2 of 2)
• Increasing in real income – more currency required as
volume of transactions increases.
• Decreasing in the nominal interest rate. The nominal
interest rate is the opportunity cost of using currency in
transactions – higher R implies greater use of credit in
transactions, and less use of currency.

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Nominal Money Demand
• Substitute using the approximate Fisher relation.

• For our experiments, suppose inflation rate is zero

(harmless).

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Figure 12.6
The Nominal Money Demand Curve in the Monetary
Intertemporal Model

Current nominal money demand is a straight line, and it will shift with changes in real income, Y, or the
real interest rate, r.

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Figure 12.7
The Effect of an Increase in Current Real Income on the Nominal
Money Demand Curve

The current nominal money demand curve shifts to the right with an increase in current real income, Y.

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Figure 12.8
The Current Money Market in the Monetary Intertemporal Model

The figure shows the current nominal demand for money curve, Md, and the money supply curve, Ms. The
intersection of these two curves determines the equilibrium price level, which is P* in the figure.

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Figure 12.9
The Complete Monetary Intertemporal Model

In the model, the equilibrium real interest rate, r*, and equilibrium current aggregate output, Y*, are
determined in panel (b). The real interest rate determines the position of the labour supply curve in panel
(a), where the equilibrium real wage, w*, and equilibrium employment, N*, are determined. Finally, the
equilibrium price level, P*, is determined in the money market in panel (c), given the equilibrium real
interest rate, r*, and equilibrium output, Y*.

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Figure 12.10
A Level Increase in the Money Supply in the Current Period

The figure shows a one-time increase in the money supply, from M1 to M2.

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The Neutrality of Money
• In the monetary intertemporal model, a level increase in
the money supply increases the price level and the
nominal wage in proportion to the money supply increases,
but has no effect on any real macroeconomic variable.

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Figure 12.11
The Effects of a Level Increase in M—The Neutrality of Money

A level increase in the money supply in the monetary intertemporal model from M1 to M2 has no effects on
any real variables, but the price level increases in proportion to the increase in the money supply. Money
is neutral.

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Shifts in Money Demand
• These shifts are important for how monetary policy should
be conducted.
• Shifts in the demand for money that occur within a day,
week or month (the very short run) are a critical for the
central bank.

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Figure 12.12
A Shift in the Supply of Credit Card Services

A decrease in the supply of credit card services does not change the equilibrium price, but equilibrium
quantity falls.

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Figure 12.13
A Shift in the Demand for Money

The money demand curve shifts to the right, causing a decrease in the equilibrium price level, P, from P1
to P2.

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Figure 12.14
Shifts in the Demand for Money

A downward-sloping curve would fit the data for 1962–1979 quite well, consistent with a stable money
demand function, but the data for 1980–2018 is not predicted well by the money demand function fit to
the 1962–1979 data.

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Sources of Shifts in the Demand for Money
• Shocks that the central bank is concerned with (in our
model): shifts in money demand, output demand, output
supply.
• Two alternative policy rules which central banks have
adopted: money supply targeting, interest rate targeting.
• Key problem for the central bank: it cannot observe the
shocks directly, and does not have timely information on all
economic variables.

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The Liquidity Trap
• Typically thought that the nominal interest rate cannot go
below zero (though in practice, not quite correct).
• There is a zero lower bound on the nominal interest rate.
• At the zero lower bound, money M and B become perfect
substitutes.
• Liquidity trap: Open market purchases of B by the central
bank will not matter.

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Figure 12.15
A Liquidity Trap

When the nominal interest rate is zero, money and government debt become perfect substitutes, so open
market operations cannot affect the price level.

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Unconventional Monetary Policy
• Since conventional monetary policy – open market
operations – does not work in a liquidity trap, central bank
can resort to (among other policies):
– Quantitative easing – purchases of long-maturity
government debt and private assets.
– Negative nominal interest rates – going below zero to the
effective lower bound, by charging banks fees on reserve
accounts with the central bank.

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Corridor Systems and Floor Systems (1 of 2)
• Bank of Canada monetary policy, as in many other
countries (with some variations) has two key elements:
– Inflation target (2% for Canada)
– Set a target for an overnight interest rate so as to achieve
the inflation target.
– Daily financial market intervention so as to achieve the
overnight interest rate target.

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Corridor Systems and Floor Systems (2 of 2)
• Daily financial market intervention by the Bank of Canada
works in a corridor system:
– Bank rate (interest rate at which the Bank lends to financial
institutions) is the upper bound on the overnight interest
rate.
– Deposit rate (on financial institution deposits at the Bank) is
the lower bound on the overnight interest rate.

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Bank of Canada Corridor System
• In late 2019, the target for the overnight repurchase
agreement (repo) rate was 1.75%.
– Bank rate was set at 2.00%
– Bank of Canada deposit rate was set at 1.50%

• Idea is that no financial institution would borrow overnight

at a rate higher than the Bank Rate, nor would a financial
institution lend overnight at a rate lower than the deposit
rate at the Bank of Canada.
• Corridor system is normal for the Bank of Canada, except
for a short period, April 2009 to June 2010, when the Bank
adopted a floor system.
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How a Corridor System Works, part I
• Excess demand for overnight credit in the financial system
is a decreasing function of the overnight interest rate.
• Demand for overnight credit declines as the interest rate
increases; supply of overnight credit increases as the
interest rate increases.
• Excess demand is quantity demanded minus quantity
supplied.
• Overnight market clears when the overnight interest rate is
such that excess demand equals zero.
• Goal of the central bank is for the overnight credit market
to clear at the target interest rate.

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How a Corridor System Works, part II
• If excess demand is zero at a higher overnight interest rate
than the target, Bank of Canada supplies repos (lends in
the overnight market) to hit the target.
• If excess demand is zero at a lower overnight interest rate
than the target, Bank of Canada does reverse repos (or
reverses), i.e. it borrows in the overnight market to achieve
its target.

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Figure 12.16
A Corridor System

The central bank’s overnight interest rate target is R%∗. A happy coincidence is if the excess demand curve
is ED0, so that the overnight market clears at the target interest rate. If the excess demand curve is ED1,
the central bank must lend in the overnight market to achieve its target, and if the excess demand curve
is ED2, the central banks must borrow.

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How a Floor System Works (1 of 2)
• Under a floor system there are significant reserves (central
bank deposits) outstanding overnight.
• For a corridor system to work, overnight reserves are
essentially zero (or reserves in excess of reserve
requirements are essentially zero).
• Floor system has been in effect in the United States since
late 2008, and Canada had a floor system April 2009-June
2010.

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How a Floor System Works (2 of 2)
• Reserves outstanding implies that excess demand for
overnight credit is perfectly elastic at the central bank
deposit rate 𝑅! .
• Financial market arbitrage implies that 𝑅! is set by the
central bank and determines the overnight interest rate, in
theory.
• Worked in Canada, sometimes not so well in the United
States.

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Figure 12.17
A Floor System

The central bank sets the interest rate on central bank deposits at Rd, and supplies sufficient reserves that
the overnight market clears at the interest rate Rd, with excess demand curve ED0. If there are
insufficient reserves in the system, then, with excess demand curve ED1, the overnight market clears at
an interest rate higher than Rd, and zero reserves are held overnight.

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