All information is provided in the course note you just need to apply these consepts to the questionsCourse Notes 8: Theories about Money and the Real Sector (revised)
Spring 2020
Topic: Adding the Money Market to the model and looking at Changes in the
Macroeconomic Equilibrium
•
•
•
We have talked about a simple model of what determines aggregate demand (YAD) in an
economy; as well as private-sector saving (Sp) and new borrowing [Ip* + G-(T-TR)]
Now we will look at the relationship between the Real Sector (Real GDP=Y), the
Loanable Funds Market, and the Money Market (which means we are also looking at the
Bond Market since they are the two assets in this simple model).
Conditions in the Money Market:
o Affect “money prices” :
▪ The nominal interest rate (i)
▪ Output prices (P)
▪ Input prices (e.g. nominal wages)
o Are affected by economic activity in the real sector and in the Loanable Funds
Market
Thus adding the Money Market allows us to analyze:
• What determines the aggregate price level (P) in the economy?
• What happens to the nominal interest rate ( i ) when there is a change in a component of
AD (e.g., an exogenous change in Ip* or G )?
• What happens when the “central bank” changes the money stock (M) in the economy?
o “ Monetary policy” is implemented by the economy’s central bank
o Here we will look at a one-time [unanticipated] change in the stock of Money (M), and
how it affects the macroeconomy under the two different aggregate-supply scenarios.
Monetary Theory
Related Reading: Mishkin Chapter 22
• 5th edition pp. 532-542 (up to the Portfolio Theories of Money Demand Section)
• 4th edition pp. 524-534 (up to the Portfolio Theories of Money Demand Section)
• 3rd edition pp. 550-560 (up to the Portfolio Theories of Money Demand Section)
Monetary Theory studies the linkages between changes in the Money supply (M) and changes in
real output (Y) and/or changes in the aggregate price level (P)
▪ Over the short run and over the long run.
Early Monetary Theory
Early Monetary Theory (Irving Fisher, early 1900s) started with the definition of Velocity and
the Equation of Exchange, and postulated that inflation was related to the growth of the Money
stock (M) relative to the growth of Real Output (Y)
•
•
Velocity (V) is defined as
V = PY
M
Thus the Equation of Exchange is an identity MV=PY
Financial Economics Econ 2121 Katherine Samolyk Course Notes 8
Page 1
Course Notes 8: Theories about Money and the Real Sector (revised)
Spring 2020
•
As we discussed in Chapter 4, velocity is something we measure (using data on M, P, and Y)
•
The fact that the equation of exchange must hold, implies that over time, there is a
relationship between the growth rates of its components:
o %∆M + %∆V = %∆P + %∆Y
• The definition of Velocity is not a theory!!!!
The Quantity Theory of Money
•
Assumes that Velocity is stable over the business cycle (%∆V = 0)
Implications of the Quantity Theory
• Since the Quantity Theory assumes that %∆V =0 (velocity is fixed)
• The Equation of Exchange yields a precise relationship between the growth rate of the
Money supply in an economy (%∆M) and the growth rate of nominal GDP (%∆P + %∆Y)
o %∆V = 0 → %∆M = %∆P + %∆Y
Early Quantity Theorists (Pre-Great Depression) also tended to have the “Classical View” of
Aggregate Supply (AS) and Aggregate Demand (AD) in the Real Sector
• They viewed input prices and output prices in the macroeconomy as flexible (P=Pflexible)
• Flexible prices were assumed to keep an economy operating at the full-employment-level
of real output (Y=Yfe)).
• In other words, market forces are assumed to work well at keeping an economy operating
at full capacity (Y = Yfe).
Putting together the Quantity Theory (%∆V =0 ) and the Classical View (Y=Yfe and
P=Pflexible)
•
•
Quantity Theory:
%∆V =0 → %∆M = %∆P + %∆Y
Classical View of the Macroeconomy: P=Pflexible → Y=Yfe
In the short run, Yfe is assumed to be fixed (i.e. %∆Yfe = 0)
• Because it takes time for the stock of inputs and/or technology to change in an economy
• Thus the two theories yield the following short-run relationship:
%∆Yfe = 0 and
•
%∆V =0
→ %∆M = %∆P
The two theories imply a direct and precise relationship between an economy’s money
growth rate and the inflation rate in the short run:
o A higher money-growth rate causes a higher inflation rate
o A lower money-growth rate causes a lower inflation rate (it can cause deflation)
Financial Economics Econ 2121 Katherine Samolyk Course Notes 8
Page 2
Course Notes 8: Theories about Money and the Real Sector (revised)
•
Spring 2020
Even during the Great Depression of the 1930s, classical economists worried about
money growth causing inflation.
o But they didn’t have the data that we have today to measure economic variables;
including changes in velocity over time.
The Quantity Theory in the Long Run
In the long run, the level of capacity real output (Yfe) in an economy can change as available
inputs and/or technology changes:
•
•
In the long run, %∆Yfe does not have to equal zero
Thus the Quantity Theory yields the following long-run relationship:
%∆M
•
= %∆P + %∆Yfe
→
%∆M – %∆Yfe = %∆P
The long-run inflation rate in an economy should reflect long-run money growth relative to
the long-run change in the full-employment level of real output.
o ↑ (%∆M – %∆Yfe ) → ↑ %∆P = π (the inflation rate)
o ↓ (%∆M – %∆Yfe ) → ↓ %∆P = π (the inflation rate)
Modern Quantity Theorists: Monetarists
•
•
•
•
•
Most notably, Milton Friedman
Believed that changes/trends in velocity over time were relatively stable/predictable
But recognized that an economy does not always operate at Yfe
Believed that targeting a money growth rate would allow a central bank to target a rate of
nominal GDP growth
o Concludes that there is a precise relationship between money and nominal GDP
o %∆V = 0 → %∆M = %∆P + %∆Y
However, as we discussed in Course Notes 3, there has been a breakdown in the stability
of both M1 velocity and M2 velocity
Institutional Factors and Velocity
As discussed in Mishkin, chapter 22, “institutional factors” can change velocity over time
• “Institutional factors “ can affect the amount of Money that individuals need to hold (on
average) to make a given volume of transactions.
• When we discussed “money” (Chapter 3 and Course Notes 3), we talked about longer-run
factors that can affect the amount of money held to make transactions
o For example, we talked about changes in the efficiency of the payments system
o Now we have ATMs everywhere, so people do not have to hold as much
currency.
o And people can transfer funds easily from savings accounts (M2) to checking
accounts (M1).
• We talked about other factors that can affect the amount of “money” that is held to make
transactions
Financial Economics Econ 2121 Katherine Samolyk Course Notes 8
Page 3
Course Notes 8: Theories about Money and the Real Sector (revised)
•
Spring 2020
o For example, Illegal activities and the underground economy affect the demand
for cash
These types of factors are called “longer-term secular trends” not associated with the
business cycle per se.
The Liquidity Preference Theory of Money Demand
• Originally was developed by John Maynard Keynes in the 1930s as an alternative to the
Quantity Theory of Money
• Other economists have built on the Liquidity Preference Theory since then.
The Liquidity Preference Theory
• Views Money as a medium of exchange
• The transactions demand for money (medium of exchange) to buy goods and services is
positively related to nominal GDP (P*Y)
o Note that the Quantity Theory also posits that M and P*Y are positively related
• But Keynes also focused on Money as a “store of value” (an alternative to holding
Bonds):
o Money is a perfectly-liquid store of value (no interest-rate or default risk)
▪ However, Money pays no interest.
The Liquidity Preference (LP) Theory assumes that the nominal interest rate on Bonds (i)
affects how much Money (versus Bonds) investors/savers want to hold in their portfolios; given
the volume of aggregate spending (P*Y)
• The Money balances that investors/savers want to hold (to make a given volume of
transactions) are inversely related to the nominal interest rate (i)
• At a higher nominal interest rate (which is the yield to maturity that an investor/saver
can earn by buying a Bond)
o Investors/savers economize on the money balances held; given aggregate
spending (P*Y)
o Since the opportunity cost of holding Money (rather than Bonds) is higher
• At a lower nominal interest rate (which is the yield to maturity that an investor/saver
can earn by buying a Bond)
o Investors/savers are willing to hold greater money balances; given aggregate
spending (P*Y)
o Since the opportunity cost of holding Money (rather than Bonds) is lower
•
Aggregate money demand in the LP model is still affected by all of the things that we
talked about when looking at the model of the Bond Market and the Money Market in the
Very-Short Run, including
o Investors/savers expectations about the future
o Uncertainty about future conditions.
But in our analysis of macroeconomic conditions over the business cycle, we will hold all of
these other factors constant. The macro model will focus on how Money-Market conditions
are related to changes in real output (Y) and output prices (P) over the business cycle.
Financial Economics Econ 2121 Katherine Samolyk Course Notes 8
Page 4
Course Notes 8: Theories about Money and the Real Sector (revised)
Spring 2020
A Liquidity Preference Model of Money Demand
One could look at the Demand for Nominal Money Balances (Md) over the Business Cycle
Md = L ( i , Y )*P
(-) (+) (+)
i : M d is negatively related to the nominal interest rate (for a given Y and a given P)
o The nominal interest rate is the opportunity cost of holding Money (instead of buying
more Bonds),
o As the interest rate increases (the yield to maturity that can be earned by buying a bond
increases), investors/savers want to hold less Money (more Bonds)
▪ Bond Buyers>Bond Sellers
▪ Investors/savers economize on money balances (given Y and P)
Y: Md is positively related to real expenditures (Y):
o At a higher Y, individuals need more M to make more transactions for goods and services
(for a given P)
o At a lower Y, individuals need less M to make fewer transactions for goods and services
(for a given P)
P: Md is positively related to the aggregate price level (P):
o At a higher P, individuals need more M to make transactions for Y because the price of
these goods and services is higher
o At a lower P, individuals need less M to make transactions for Y because the price of
these goods and services is lower
However, the relationship between the price level (P) and the demand for nominal money
balances (M d) is proportional
•
•
•
Since nominal money balances (M) are held to make expenditures on real output (Y)
o If P doubles—you need to hold twice as much M to make the same real
expenditures (Y)
In other words, the demand for nominal money balances changes one-for-one with the
aggregate price level (P), all else being equal
For example,
If P1 = 2*P0 (holding other factors constant)
▪ M d0 = L ( i , Y ) *P0
▪ M d1 = L ( i , Y ) *2P0
Liquidity Preference and the Demand for Real Money Balances
• The demand for nominal money balances varies proportionately with output prices (P)
• Hence the standard Liquidity Preference Model divides both sides of the equation
describing the demand for nominal money balances by P to quantify the demand for “real
Financial Economics Econ 2121 Katherine Samolyk Course Notes 8
Page 5
Course Notes 8: Theories about Money and the Real Sector (revised)
Spring 2020
money balances” (M/P)
The Demand for Real Money Balances
The Demand for “Real Money Balances” in the Liquidity Preference Model is thus:
Md = L ( i , Y )
P
(-) (+)
•
At a higher nominal interest rate, investors/savers will want to hold lower real money
balances; given the level of aggregate transactions on real GDP (Y).
o The opportunity cost of holding Money rather than buying a Bond is higher.
•
At a lower nominal interest rate, investors/savers will be willing to hold higher real
money balances; given the level of aggregate transactions on real GDP (Y).
o The opportunity cost of holding Money rather than buying a Bond is lower
i
iB
B
A
iA
L ( i , Y)
L ( iB )
L ( iA )
Real Money Balances
A change in real output (Y) , changes the Transactions Demand for Money and shifts the money
demand curve
•
•
An increase in real output (Y) increases the demand for real money balances
A decrease in real output (Y) decreases the demand for real money balances
Financial Economics Econ 2121 Katherine Samolyk Course Notes 8
Page 6
Course Notes 8: Theories about Money and the Real Sector (revised)
Spring 2020
i
A
B
L ( i , Y1 ) is higher when income
is higher
iA
L ( i , Y0 ) is lower when income
is lower
Real Money Balances M
P
What about the aggregate price level (P)?
i
L(i,Y)
Real Money Balances M/P
In the framework looking at real money balances, people care about the ratio of M to P —the
real purchasing power of the outstanding money stock
We will see how changes in the price level (P), change the supply of real money balances, for a
given Money stock (M)
Financial Economics Econ 2121 Katherine Samolyk Course Notes 8
Page 7
Course Notes 8: Theories about Money and the Real Sector (revised)
Spring 2020
The Supply of Real Money Balances
•
•
•
The supply of real money balances =M/P
The outstanding stock of Money (M) and the aggregate price level (P) will determine the
supply of real money balances
Again we will assume in our simple model that the Central Bank sets M
i
The supply of real money balances = M0
P0
Where M0 is set by the Central Bank
And P0 is the current aggregate price level
M0
P0
Real Money Balances
(Note that the equilibrium in the Money Market is the same whether we look at nominal money
balances or real money balances)
What does it mean for the Money Market to be in an equilibrium?
i
i0
L ( i , Y0 )
M0
P0
Real Money Balances M/P
Financial Economics Econ 2121 Katherine Samolyk Course Notes 8
Page 8
Course Notes 8: Theories about Money and the Real Sector (revised)
Spring 2020
•
At the equilibrium nominal interest rate i0, investors/savers are willing to hold the current
stock of Money (and Bonds) given their transactions demand for real money balances
o Here we are dividing by P to look at real money balances
•
At i> i0 , the demand for money is too low; investors/savers would prefer to hold more Bonds
at the high interest rate (the yield to maturity they would earn if they bought more bonds)
o So Bond buyers>Bond sellers (moving along the curve)
•
At i< i0 , the demand for money is too high; investors/savers would prefer to hold more
money, given the low nominal interest rate (they would earn if they bought more bonds)
o So Bond buyers
Purchase answer to see full
attachment
Why Choose Us
- 100% non-plagiarized Papers
- 24/7 /365 Service Available
- Affordable Prices
- Any Paper, Urgency, and Subject
- Will complete your papers in 6 hours
- On-time Delivery
- Money-back and Privacy guarantees
- Unlimited Amendments upon request
- Satisfaction guarantee
How it Works
- Click on the “Place Order” tab at the top menu or “Order Now” icon at the bottom and a new page will appear with an order form to be filled.
- Fill in your paper’s requirements in the "PAPER DETAILS" section.
- Fill in your paper’s academic level, deadline, and the required number of pages from the drop-down menus.
- Click “CREATE ACCOUNT & SIGN IN” to enter your registration details and get an account with us for record-keeping and then, click on “PROCEED TO CHECKOUT” at the bottom of the page.
- From there, the payment sections will show, follow the guided payment process and your order will be available for our writing team to work on it.