Transcript THE ROLE OF MONEY IN MACROECONOMICS

Chapter 36 - Lipsey
FINANCIAL ASSETS
Wealth
Bonds
Interest
earning
assets
Money
Claims on
real capital
Medium of
exchange
THE RATE OF INTEREST AND PRESENT VALUE
• Present Value – of a bond or any asset refers
to the value now of the future payments to
which the asset represents a claim
Present Value = Future Value/(1+interest rate)n
• Present value of an asset is negatively related
to the interest rate
PRESENT VALUE AND MARKET PRICE
• Present value is important because it establishes
the market price for an asset
• In a free market, the equilibrium price of any
asset will be the present value of the income
stream that it produces.
THE RATE OF INTEREST AND MARKET PRICE
• A rise in the market price of an asset is equivalent
to a decrease in the rate of interest earned.
• The sooner is the maturity date of a bond, the less
responsive bond value is to interest rate changes.
THE SUPPLY OF MONEY
• Money supply is a stock and not flow
• Monetary authorities (Central Bank) control
the total money stock directly.
• In other words money supply is exogenously
fixed by policy-makers.
DEMAND FOR MONEY
• The opportunity cost of holding money is the
extra interest that could have been earned if
that money were used to purchase bonds.
• Motives of holding money
– Transactions Motive
– Precautionary Motive
– Speculative Motive
REAL AND NOMINAL MONEY
BALANCES
Nominal money demand
The demand for money in monetary units.
Real money demand
Number of units of purchasing power that the public wishes
to hold in the form of money balances expressed in constant
prices.
Real Money Demand = (Nominal money demand/Price level)
The Quantity Theory of Money
1. Demand for money = Value of transactions (k) *Nominal Income (PY)
MD = kPY
2. Supply of money set by the Central Bank
MS = M
3. Equilibrium: Money demand = Money Supply
MD = MS
4. Substituting equations 1 and 2 into 3 yields
M = kPY
5. Velocity of Money (V): assumed as a constant
V = 1/k
Therefore quantity theory of money is presented by:
MV = PY
Total Demand for Money
The function relating money demanded to the rate of
interest is called the demand-for-money function.
Fig. 36.1 – the demand for money as a function of interest rate,
income and price level.
Monetary Forces and National
Income
Monetary Equilibrium
•Occurs when the
demand for money
equals the supply of
money
•The rate of interest
will adjust to ensure
this equilibrium
THE TRANSMISSION
MECHANISM
Monetary disturbances cause
interest rate to change.
Changes in interest rate affect
investment expenditure.
Investment expenditure in
turn affect aggregate demand.
Monetary Disturbances & interest
rate changes – Fig 36.3
The effects of changes in money supply
on investment expenditure – Fig 36.4
The effects of
changes in
money supply
on aggregate
demand –Fig
36.5
Expansionary
Monetary Shock
Increase in
money
supply
Decrease in
money
demand
Excess supply of money (monetary disequilibrium)
Attempt to reduce money holdings by buying bonds
A fall in the interest rate
An increase in interest-sensitive expenditure
An increase in equilibrium real national income
Contractionary
Monetary Shock
Decrease in
money
supply
Increase in
money
demand
Excess Demand for money (monetary disequilibrium)
Attempt to increase money holdings by selling bonds
A rise in the interest rate
An reduction in interest-sensitive expenditure
An reduction in equilibrium real national income
AN ALTERNATIVE DERIVATION
OF THE AGGREGATE DEMAND
CURVE:
IS/LM
THE IS CURVE
FIG. 36.7
• The IS curve
shows the
equilibrium level
of national
income
associated with
each given rate of
interest
• Equilibrium in the
goods market
THE LM CURVE
FIG. 36.8 The LM curve shows the combinations
of national income and the interest rate that
are consistent with the equality of money
demand and supply and given price level.
IS-LM AND AGGREGATE DEMAND
FIG. 36.9 – the AD
curve plots the ISLM
equilibrium
level of national
income for each
given price level,
holding
all
exogenous
expenditures and
the nominal money
supply constant.
AGGREGATE DEMAND, THE
PRICE LEVEL, AND
NATIONAL INCOME
THE EFFECT OF A MONEY SUPPLY
CHANGE IN THE SHORT RUN
• An increase in money
supply in the short
run – shifts LM to the
right – shifts AD to the
right – upward
pressure on prices –
real money supply
falls & wealth effects –
IS and LM shift left
slightly to point A.
THE EFFECT OF A MONEY SUPPLY
CHANGE IN THE LONG RUN
• An increase in money
supply in the long run –
LM shifts to the right –
AD shifts to the right –
prices rise – inflationary
gap drive wages higher
– shift leftward in SRAS
curve increasing prices
more – leftward shift in
IS & LM. Output returns
to potential level.
THE EFFECT OF A CHANGE IN FISCAL
POLICY IN THE SHORT RUNs
• An expansionary fiscal
policy starting from
equilibrium, has the
same short and long
run effects on national
income prices as an
expansionary
monetary policy but it
has different effects
on the composition of
expenditure.
THE EFFECT OF A CHANGE IN FISCAL
POLICY IN THE LONG RUN
• The adjustment from the long to short run
case is the same for fiscal policy changes as for
monetary policy since it involves a leftward
shift in the SRAS curve which results from
increases in input prices specially wages.
• There may long run implications of the fact
that the government is now running a budget
deficit when it was not before.