Module 28/31- The Money Market and the Equation of Exchange J.A.SACCO

Graphing Monetary Policy Three types of “Money Demand” Transaction Demand- hold money as a medium of exchange. National income increase, the demand for money increases Precautionary Demand- unplanned emergencies Asset Demand- Money as a store of value instead of other assets.

Graphing Monetary Policy Demand for Money Curve Why downward sloping? At high interest rate MD is low because rather hold other assets -opportunity cost of holding money is high (give up interest on other assets) At low interest rate, MD is high because rate of interest on holding other assets is low -opportunity cost of holding money is low Int. rate / Q.D. of Money Int. rate /Q.D. Money *Remember a change in the interest rate is only a movement up and down the Money demand curve

Graphing Monetary Policy Demand for Money Curve Shifts? Changes in price level PL increase/ MD increase PL decrease/MD decrease Changes in Real GDP GDP increase/ MD increase GDP decrease/ MD decrease Changes in technology- ATM’s, credit cards Tech. increase/ MD decrease Tech. decrease/ MD increase *Remember a change in the money demand curve is a shift of the curve

Graphing Monetary Policy Money Supply Curve Always vertical, stock concept MS increase, IR decrease, expansionary MS decrease, IR increase, contractionary Key Point- Interest rate in the money market is determined by the price of bonds in the bond market

Expansionary Monetary Policy Fed. Buys Bonds Money Supply? Interest Rate? Price of Bonds? Invest? Consump? GDP? Inflation? Unemployment? Show changes in Money Market graph Show corresponding changes in investment graph Draw an AD/AS model starting with a recessionary gap and show the results of the monetary expansion.

Expansionary Monetary Policy Fed. Buys Bonds Money Supply? Interest Rate? Price of Bonds? Investment/Consumption? GDP? Inflation? Unemployment?

Contractionary Monetary Policy Fed. Sells Bonds Money Supply? Interest Rate? Price of Bonds? Invest? Consump? GDP? Inflation? Unemployment? Show changes in Money Market graph Show corresponding changes in investment graph Draw an AD/AS model starting with a expansionary gap and show the results of the monetary contraction.

Contractionary Monetary Policy Fed Sells Bonds Money Supply? Interest Rate? Price of Bonds? Invest/Consumption? GDP? Inflation? Unemployment? ---------------- ----------------

The Equation of Exchange How much money is too much money? Mathematical expression of the “quantity theory of money” devised by Irving Fisher Aggregate amount spent by buyers Total value of all goods and services = MV=PQ Equation to explain how exchange and the role of “M” and “V” in determining the level of output (P &Q)

The Equation of Exchange M = Stock of Money- M1 money supply. Currency, travelers checks, checkable deposits. V = Velocity of Money-Income (GDP) velocity of circulation. The average number of times a dollar is spent on final goods and services per time (usually a year).

The Equation of Exchange P = The average price of the final goods and services in GDP. The GDP Deflator. Q = Real Output. The quantity of goods and services in GDP. Real GDP in dollars of the base year of the deflator.

The Equation of Exchange Example- M= $300 B and V= 5, therefore if Q = $750B then P = ? $2 per unit Why is this equation important to the money supply? Provides insight into what would happen to output(Q) and prices (P) when money supply changes.

The Equation of Exchange Assume Velocity of Money (V) is constant. If the Supply of Money (M) increases, then either Price (P) or Output (Q) or both must increase. The effect of the change in M on P and Q will depend on the state of the economy.

Crude Quantity Theory of Money and Prices If the economy is operating well below full employment (recession), an increase in M will tend to raise Q (ouput) more than P (price) as unemployed resources are re- employed. If the economy is already at full employment or above, any increase in M will tend to raise P more than Q. The increase in M will be purely inflationary. Thus the state of the economy will have a major impact on whether or not to increase the money supply.

Crude Quantity Theory of Money and Prices So if Q (GDP) increases by 3-5% a year, any increase in M above 5% merely increases the price level (demand pull inflation ) Increases of less than 3% in M means Q cannot increase by 3% so the price level will fall, recession. The key is to grow the money supply with the growth of output (real GDP) in order to maintain economic stability.