Macroeconomic Policies Notes (Incomplete)

H2 Economics Chapter 11, 12 and 13 Notes This document is intended as a summary of the points provided in the NJC 2024 H2 Economics Chapter 11, 12 and 13 Seminar Notes. It is to be used as a study guide to provide a structure for studying the Chapter 11, 12 and 13 Notes. 1 Interest Rate Monetary Policy 1.1 Theory of Liquidity Preference Keynes proposed that money can be treated like a commodity in his Theory of Liquidity Preference. Similar to how goods and services are bought by consumers from producers, there is a market for money, as money can be ‘bought’ by households and firms for a ‘price’. This price is more commonly known as the interest rate of a country’s central bank. Liquidity Preference is the preference for holding money 1 over other kinds of assets. Why do we use the term ‘other kinds of assets’? People store their wealth not only in terms of money but also other financial assets such as bonds and stocks. A reduction in the quantity of money in circulation does not translate to money simply disappearing. Instead, people convert their money into assets so that they retain their wealth while holding less money. The Liquidity Preference (Money Demand) Curve There are three main purposes for holding money. Should a question require explanation on determinants of liquidity preference, it is important to link to these concepts. (1) Transactionary Purpose: Money needed to facilitate payment for daily transactions of goods and services. (2) Precautionary Purpose: Money held as a precaution for unexpected items of expenditures like sickness or accidents. (3) Speculative Purpose: Money held instead of investing it in bonds or other assets. You can think of this as money that is held because it is not worth it to buy other assets.) 1 Holding money refers to the act of keeping cash readily available instead of investing or spending it immediately. A portion of one's wealth is held in the form of currency or cash equivalents, such as deposits in bank accounts or physical currency. 1

NJC H2 Economics 2024 Chapter 11/12/13 As the government increases interest rates, the cost of borrowing 2 money from the bank increases since a borrower would have to repay a greater sum of money in the future than if the interest rate was lower. Hence, households and firms would borrow less money. Conversely, if the interest rate was lowered, more money would be borrowed. This inverse relationship between interest rate and quantity of money borrowed is similar to the inverse relationship between price and quantity demanded of other commodities. Hence, liquidity preference can be thought of as the ‘demand for money’ and is a generally downward sloping curve The Money Supply Curve Governments can directly change their country’s interest rates to influence consumption and investment. But it is actually harder to control spending in this way as it is less direct, so frequently they influence interest rates by changing the amount of money in circulation. When the government wants to decrease money in circulation, they sell ‘bonds’, which is basically a deal to the public to say “If you pay us money now, we will pay you back more money in the future”. People who pay the government money through this medium are called ‘buyers’. These actions withdraw money from the banking accounts of buyers when they use money in the bank to buy these bonds, causing banks to have less money available to lend. As a result, banks' reserves shrink and their ability to issue new loans diminishes, causing banks to become more selective about who they lend to, so they increase interest rates as a measure to ration money. On the other hand, to increase money in circulation, the government buys bonds. In effect, they buy bonds back from people who have previously bought bonds by putting money into their banking accounts. And in doing so, banks’ reserves increase which hence decreases the interest rates in banks This is the concept of money supply. The central bank, owned by the government, may determine the exact quantity of money to be put in circulation by buying and selling bonds to the free market. Changes in the interest rate does not affect the ability of the central bank to print money and hence the money supply is hence represented by a vertical line which is independent of the interest rate. 2 Theoretically, it is possible to analyse the inverse relationship between interest rate and money via the returns from saving, but the explanation for that is slightly longer and more difficult to write. 2

NJC H2 Economics 2024 Chapter 11/12/13 The Liquidity Trap When the interest rate became very low, it was observed that increasing the money supply by buying bonds did not lower interest rates any further. This is because lowering the interest rates further would make banks unwilling to lend money as they would no longer be profitable and cannot operate. Hence, increasing money supply ceases to increase spending as cost of borrowing can no longer be changed. While the quantity of money being held increases with money supply, the quantity of money spent does not increase. This is illustrated by a horizontal portion on the liquidity preference curve. The Market for Money Taking all the above into consideration, the demand-supply diagram for money looks something like this. ‘Income’ VS ‘Wealth’ VS ‘Money’ Income : Payment received from providing factors of production. The sum of money earned from working and money received from rent, interest and dividends. Wealth : Difference between financial assets and liabilities. 3 Money : A financial asset used to purchase goods and services. In the ‘A’ Level syllabus, this primarily refers to coins, notes and demand deposits. These terms cannot be used interchangeably in Economics as they are different concepts and it is a conceptual error to conflate them. 3 It is important to distinguish between changes in wealth and changes in the composition of wealth. When one repays a loan by writing a cheque, there is a decrease in debt that is equal to the decrease in money, so the decrease in liabilities is matched by a decrease in assets and there is no change in wealth, but only in the composition of wealth. 3

NJC H2 Economics 2024 Chapter 11/12/13 1.2 Causes of Interest Rate Changes Determinants of Interest Rates Determinant of Liquidity Preference Key Analysis/Technical Terms Business and Consumer Expectations Transactionary demand and expectations of future interest rates and bond prices, speculative demand, buy higher value bonds now to sell in secondary market for profits Economic Growth Transactionary demand via purc