Lecture notes Prepared by Anton Ljutic

© 2004 McGraw–Hill Ryerson Limited The Money Market CHAPTER EIGHT

© 2004 McGraw–Hill Ryerson Limited Recognize that demand for money is not the same as desire for income Distinguish two types of money demand Explain the downward sloping money demand curve Explain and illustrate graphically how the money supply and demand affect the equilibrium interest rate Describe two views of how the money market affects the level of real GDP and inflation This Chapter Will Enable You to:

© 2004 McGraw–Hill Ryerson Limited The Supply of Money The supply of money is determined by the Bank of Canada, which, can and and does change the money supply as it sees fit MS Rate of interest Quantity of money Figure 8.1

© 2004 McGraw–Hill Ryerson Limited The Demand for Money Transactions demand for money –The desire of people to hold money as a medium of exchange, that is, to effect transactions –The major determinants are the level of real income and the level of prices Asset demand for money –The desire by people to use money as a store of wealth, that is, to hold money as an asset –The major determinant is the rate of interest

© 2004 McGraw–Hill Ryerson Limited Transactions Demand r Q of M MD T r1r1 r2r2 The transactions demand for money is unrelated to the rate of interest The transactions demand for money is unrelated to the rate of interest Q Figure 8.2A

© 2004 McGraw–Hill Ryerson Limited Asset Demand There is an inverse relationship between the asset demand for money and the interest rate There is an inverse relationship between the asset demand for money and the interest rate r Q of M r1r1 Q1Q1 r2r2 Q2Q2 MD A Figure 8.2B

© 2004 McGraw–Hill Ryerson Limited Total Money Demand r Q of M It is the addition of the transactions and asset demand It is the addition of the transactions and asset demand MD= MD T + MD A MD T MD A

© 2004 McGraw–Hill Ryerson Limited The Demand for Money is Determined by: The level of transactions (real GDP) The average value of transactions ( the price level) The rate of interest –The annual rate at which payment is made for the use of money (borrowed funds); a percentage of the borrowed amount

© 2004 McGraw–Hill Ryerson Limited Shortage Equilibrium in the Money Market MS MD Q of MQ1Q1 r1r1 r2r2 r3r3 Surplus At equilibrium interest rate, r1, there is no surplus or shortage of money. At any other rate there is either a shortage (e.g., r2) or a surplus (e.g., r3). At equilibrium interest rate, r1, there is no surplus or shortage of money. At any other rate there is either a shortage (e.g., r2) or a surplus (e.g., r3). Figure 8.3

© 2004 McGraw–Hill Ryerson Limited A Shift in the Supply of Money Q of M r1r1 r2r2 Q1Q1 Q2Q2 MS 1 MS 2 Surplus Figure 8.4 An increase in the supply of money from MS 1 to MS 2 will initially cause a surplus of money at the prevailing interest rate r1. People will want to dispose of the surplus by buying bonds. This will cause bond prices to rise and interest rate to fall to r2. Figure 8.4 An increase in the supply of money from MS 1 to MS 2 will initially cause a surplus of money at the prevailing interest rate r1. People will want to dispose of the surplus by buying bonds. This will cause bond prices to rise and interest rate to fall to r2. MD

© 2004 McGraw–Hill Ryerson Limited An Increase in the Demand for Money Total demand for money will change if nominal GDP changes. A higher price level or a higher GDP will shift the demand for money curve to the right. This will initially cause a shortage of money, causing people to sell some of their bonds and causing bond prices to fall and interest rates to rise from r1 to r2 Total demand for money will change if nominal GDP changes. A higher price level or a higher GDP will shift the demand for money curve to the right. This will initially cause a shortage of money, causing people to sell some of their bonds and causing bond prices to fall and interest rates to rise from r1 to r2 Q of M r1r1 r2r2 MD 1 MS 1 Shortage MD 2

© 2004 McGraw–Hill Ryerson Limited Money Market’s Effect on the Economy The money market and the product market are intrinsically linked The transmission process illustrates that the interest rate is the link between the two markets –Transmission process The Keynesian view of how changes in money affect (transmit to) the real variables in the economy Investment demand –Investment is the most affected by changes in the interest rate and the relationship is inverse

© 2004 McGraw–Hill Ryerson Limited A Change in the Price Level (I) An increase in AS leads to a decrease in P AS P An increase in AS leads to a decrease in P AS P P1P1 P2P2 AS 1 AS 2 AD Y1Y1 Y2Y2

© 2004 McGraw–Hill Ryerson Limited A Change in the Price Level (II) A decrease in P leads to a decease in MD which leads to a decrease in r P MD r A decrease in P leads to a decease in MD which leads to a decrease in r P MD r MD 1 MD 2 r1r1 r2r2 Y

© 2004 McGraw–Hill Ryerson Limited A Change in the Price Level (III) A decrease in r leads to an increase in I r I A decrease in r leads to an increase in I r I ID I1I1 I2I2 r2r2 r1r1

© 2004 McGraw–Hill Ryerson Limited A Change in the Price Level (IV) An increase in I leads to an increase in Y An increase in I leads to an increase in Y P1P1 P2P2 AS 1 AS 2 AD Y1Y1 Y2Y2 Summing up: AS up => P down P down => r down r down => I up I up => Y up Summing up: AS up => P down P => r down r => I up I => Y up

© 2004 McGraw–Hill Ryerson Limited Effect of an Increase in Money Supply (I) An increase in the money supply leads to a decrease in the rate of interest Lower rate of interest leads to an increase in investment Since P has not changed, an increase in investment results in a shift in AD to AD

© 2004 McGraw–Hill Ryerson Limited Y1Y1 Y2Y2 Effect of an Increase in Money Supply (II) r1r1 r2r2 Q1Q1 Q2Q2 MS 1 MS 2 MD P1P1 AD 1 AD 2 ID r1r1 r2r2 I1I1 I2I2

© 2004 McGraw–Hill Ryerson Limited The Monetarist View Monetarism –An economic school of thought that believes that cyclical fluctuations of GDP and inflation are usually caused by changes in the money supply –GDP determination can be summarized by the equation of exchange

© 2004 McGraw–Hill Ryerson Limited Equation Of Exchange (I) It is a formula that states that the quantity of money (M) times the velocity of money (V) is equal to nominal GDP (price (P) times real GDP (Q)). MV=PQ –Velocity of money ( or velocity of circulation) The number of times per year that the average unit of currency is spent (or turns over) buying goods and services The Monetarists believe that V is constant If we assume full employment and V is constant, any increase in M will have a direct and proportional impact on the price level

© 2004 McGraw–Hill Ryerson Limited Equation Of Exchange (II) MV = PQ Nominal GDP = M x V Nominal GDP = P x Q 1 2 3

© 2004 McGraw–Hill Ryerson Limited Demand for money is not the same as desire for income There are two types of money demand The demand for money curve is downward sloping money Could you explain and illustrate graphically how the money supply and demand affect the equilibrium interest rate? Describe two views of how the money market affects the level of real GDP and inflation Chapter Summary: What to Study and Remember