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EC 100 Macro Week 2 The Money Market 1. Discussion of LT Week 2 -Last week: discussed concept of fiscal policy multipliers – how does nominal GDP change.

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Presentation on theme: "EC 100 Macro Week 2 The Money Market 1. Discussion of LT Week 2 -Last week: discussed concept of fiscal policy multipliers – how does nominal GDP change."— Presentation transcript:

1 EC 100 Macro Week 2 The Money Market 1

2 Discussion of LT Week 2 -Last week: discussed concept of fiscal policy multipliers – how does nominal GDP change if there is an increase in government expenditure? -Note: we abstracted from what happens with prices (P), and we abstract with what happens on the capital markets (interest rates) in which the government needs to borrow in order to finance an increase in G. -We saw: government multiplier > tax multiplier in absolute value -We also saw: balanced fiscal policy (i.e. financing G with T) is not macroeconomically neutral. -This week: begin exploring money and lending, the LM curve and combine this with the IS curve. -We now explain two variables: (nominal) GDP Y and interest rates r. 2

3 Problem 1 Why would it be wasteful if the bank only kept all your money in its vaults until you wanted it back? – In such a system, there would be no bank lending – So loans could only be given from one individual to others to finance new ideas, startups or investment project – Hence investment would fall – Individuals who have excess funds may search for investment opportunities, such matching is however difficult (search cost etc) – This is inherently inefficient, as institutionalized lending serves as a way to pool risks. A bank gives out loans, some are very successful – others are not – lending through bank combines these risks. – Without fractional reserve banking – no real monetary policy through manipulation of reserve requirement ratio (see next problem). 3

4 Problem 2 Explain how the banking system as a whole creates more deposits from a given initial deposit at a single bank. The intuition is very similar to the case of the fiscal policy multipliers Imagine you put $ 100 into your bank account The bank is only required to keep $10 [depending on the reserve requirement] and can lend out the remaining $90. This is going to end up on somebody elses bank account. Again, the bank only needs to keep $9 and can lend out the remaining $81. This again… keeps only $8.1$ and lends out the remaining $72.9$ This continues infinately How much money is created with the initial $100? 4

5 Problem 2 5

6 Problem 3 Why do people willingly hold cash when those funds could instead be earning interest if deposited at a bank? – Transactions motive: It is costly to go to the bank to get money for transactions. So individuals economize on this transaction cost by holding only the money they need for a particular time period in cash and putting the rest on the bank account. New technologies can reduce the transactions motive – Examples… – Safety/ insurance motive: Is it safe to trust the banks? What happens in case of a bank run? How do governments try to get you to trust the banks? 6

7 Problem 4 What effect would you expect a general rise in real interest rates (i.e., the excess of the rate of interest over the rate of inflation) to have on the demand of money? How would your behaviour change if a bank offered for your deposits an interest rate of 50 per cent per month? If real-return is high – opportunity cost of holding cash is very high… 7

8 Problem 4 Key distinction – again, I know this may sound stupid – ensure that you are always aware of whether you shift a line or you move along a line (and why). Here we are asked to think about how money demand changes as we move along the line (vary the real interest rate) 8

9 Problem 5 What are the effects of a fall in the money supply? Trace the effects through the money market into the goods market. First a very quick and easy answer It is important that you understand this process Verbally: – The Central Bank reduces high-powered money (e.g. by selling bonds). – There is a money-multiplier reduction in the money supply. – The interest rate rises. – Investment falls. – GDP falls through the investment-spending multiplier effect. 9

10 Problem 5 10 Money market and Goods Market Five steps: a decrease in the monetary base leads to (1) a magnified fall in money supply via (2) the money supply multiplier, shifting leftwards the money- supply schedule, and leading to (3) an increase in the interest rate. A higher interest rate lowers investment, shifting downwards (4) the C+I+G schedule, leading to (5) a magnified reduction in equilibrium income.

11 Problem 5 11 This is only half the story… A fuller analysis studying the LM curve and IS curve. What happens to the LM curve? LM curve (all combinations of Y and R such that Money market in equilibrium) shfits to the left. IS curve: All combinations of Y and r consistent with equilibrium in the goods market Intersection of the two: gives levels of (Y,r) that are consistent with both money market equilibrium and goods market equilibrium. So we can tell this story using three pictures instead of two!

12 Problem 5 What does the third picture look like? (next weeks class more on this) – there is some crowding out going on. 12 LM (M S ) IS Y1Y1 Y0Y0 LM (M S ) r0r0 r1r1 r2r2

13 Problem 6 Explain the meaning of the following actions by the Bank of England, and their effects on the money market and hence the goods market: (a) open market operations; (b) an increase in reserve requirements; and (c) an increase in the interest rate. 13

14 Problem 6 Open market operations: Suppose the government sells bonds (if it buys them, the direction of changes that follow are all reversed but the reasoning is comparable), taking money from the public for them. Then the public holds more bonds and less money. Via the money multiplier, the supply of money falls. Goods market effects… An increase in reserve requirements: The required increase in reserves lowers the money multiplier. Thus, for a fixed quantity of high-powered money, the supply of money falls. Goods market effects… An increase in the interest rate: This doesnt change the money supply or demand schedules. However, the quantity of money demanded by the public falls, i.e., money market equilibrium slides up the money demand schedule. Goods market effects… 14

15 Problem 7 Explain the effects on GDP of (a) an increase in the money supply; (b) an increase in government spending in a model with a money market. Note part a) is the same as in Problem 5, just with the signs reversed (will now have a positive effect on GDP). Again, you should be able to show this… Only discuss part b) 15

16 Problem 7 b) 16

17 Problem 7 b) 17

18 Problem 7b) graphically Y1 – Y0 = 1/(1-b) * delta*(G1-G0) 18 LM (M S ) IS(G0) Y1Y1 Y0Y0 r* r0r0 IS(G1) Y*

19 Problem 8 19

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