Transcript Document

Chapter 10 The
Demand for Money and
the Price Level
Concepts of Money

Fiat money
 No
intrinsic value;
 The face value is enforced by the government;
 No interest paid.

Levels of aggregation
 Monetary base


Currency held by the public;
Currency held by banks.
 M1


Currency held by the public;
Checkable deposits.
The Demand for Money

The use of household income
PC+M+B+PK=+wL+i(B+PK)
Money v.s. other assets: not interest-bearing.
 Households could allocate their assets toward
interest-bearing types by minimizing their
money balances.
 Why hold money?

 For
convenience.
 Trade off between interest earnings and daily
transaction costs.
The Demand for Money

The interest rate
 Higher
interest ratehigher opportunity cost of
holding moneyMd/P decreases.

The price level
 Real
income remain unchanged;
 Md/P remain unchanged.

Real income
 Higher
real incomemore transaction needs
Md/P increases;
 Md/P may increase less than proportionally.
The Demand for Money

The money demand function
Md
 L( Y , i )
P
(  ) ( )
Determination of the Price level
Ms is exogenously set by the central bank.
 Equilibrium condition

Ms=PL(Y, i)
P is determined by the equilibrium condition
on the money market.
 Other nominal prices adjust quickly to clear
markets

 Labor
market: w;
 Rental market: R.
Determination of the Price level
Determination of the Price level

A Change in the Nominal Quantity of Money
 At
the new equilibrium, Y and i are unaffected;
 Md curve remain unchanged;
 P varies in proportion to Ms.
 w/P remain unchangedw varies in proportion to
P.
 R/P remain unchangedR varies in proportion to
P.
 i=(R/P)- remain unchanged.
 Y remain unchanged.
Determination of the Price level

A Change in the Nominal Quantity of Money
Determination of the Price level

The Neutrality of Money
 All

real terms remain unchanged.
K, , L, Y, w/P, R/P, i.
 Nominal


prices vary in proportion to Ms.
P, w, R.
Non-nerutal money
 Nominal
prices are sticky in the short-run.
Determination of the Price level

A Change in the Demand for Money
 Real
demand for money decreased;
 The money demand curve rotates counterclockwisely;
 P increased;
 Real terms unaffected.
Determination of the Price level

A Change in the Demand for Money
Determination of the Price level

The Cyclical Behavior of the Price Level
 Recession:
lowers Y and i;
YL(Y, i)
 iL(Y, i)

 Empirical
evidence suggests that the first effect is
stronger.
 P is countercyclical.
 The source of business cycles is the supply side

Less goods bid for money during recession.
Cyclical Behavior of U.S. Real GDP
and the Price Level
Price-Level Targeting and
Endogenous Money

Ms may respond to economic events.
 Price-level

targeting: P  P
Determination of nominal money supply
M  PL(Y , i)

Trend growth of money
Y
is growing in the long run;
 Price-level targeting requires that Ms grows
accordingly.
Price-Level Targeting and
Endogenous Money

Cyclical behavior of money
 RBC
theory suggests that Y and i are procyclical;
 Money demand is more responsive to Y than to i;
 L(Y, i) is procyclical;
 Price-level targeting requires that M be procyclical;
 M is empirically weakly procyclical;
 The policy has weakened the countercyclical
pattern of P.