Macroeconomics Chapter 101 The Demand for Money and the Price Level C h a p t e r 1 0

Macroeconomics Chapter 102

3 Concepts of Money  Fiat money has value due to government fiat, rather than through intrinsic value.  Commodity money, such as gold and silver coins, which do have intrinsic value.  High-powered money, which adds the deposits held by banks and other depository institutions  At the Federal Reserve. Another name for high-powered money is the monetary base.

Macroeconomics Chapter 104 Concepts of Money  Monetary aggregate A monetary aggregate is the total dollar stock of a group of financial assets defined to be money. The most common definition, called M1 Checkable deposits issued by banks and other financial institutions.

Macroeconomics Chapter 105

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7 Concepts of Money  Monetary aggregate M2 includes household holdings of savings deposits, small-time deposits, and retail money-market mutual funds. The M2 definition goes beyond the concept of money as a medium of exchange. In our model, it is best to use a narrower definition of money, for example, as currency held by the public.

Macroeconomics Chapter 108 The Demand for Money  Money is hand-to-hand currency Assume that the interest rate paid on money is zero.  Bonds and ownership of capital Interest-bearing assets These assets pay a positive return to the holder.

Macroeconomics Chapter 109 The Demand for Money  The household budget constraint in nominal terms PC + ∆B + P · ∆K = π + wL + i · ( B+ PK) nominal consumption + nominal saving = nominal income

Macroeconomics Chapter 1010 The Demand for Money  “ demand for money, ” M d, The average holding of money that results from the household ’ s optimal strategy for money management.

Macroeconomics Chapter 1011 The Demand for Money  The Interest Rate and the Demand for Money A higher interest rate, i, provides a greater incentive to hold down average holdings of money, M, in order to raise average holdings of interest-bearing assets, B + PK. That is, with a higher i, households are more willing to incur transaction costs in order to reduce M

Macroeconomics Chapter 1012 The Demand for Money  The Interest Rate and the Demand for Money We predict, accordingly, that an increase in i reduces the nominal demand for money, M d. For a given price level, P, we can also say that a higher i lowers the real demand for money, M d /P.

Macroeconomics Chapter 1013 The Demand for Money  The Price Level and the Demand for Money Suppose that the price level, P, doubles. The nominal demand for money, M d, doubles. Since M d and P have both doubled, the ratio, M d /P, is the same. The result is that the real demand for money, M d /P, does not change when P changes.

Macroeconomics Chapter 1014 The Demand for Money  Real GDP and the Demand for Money Assume now that nominal income doubles, while the price level, P, is unchanged. Households would double their nominal demand for money, M d. Since P is constant, the real demand for money, M d /P, also doubles.

Macroeconomics Chapter 1015 The Demand for Money  Real GDP and the Demand for Money Economies of scale in cash management, at higher incomes households hold less money in proportion to their income.

Macroeconomics Chapter 1016 The Demand for Money  Other Influences on the Demand for Money Payments technology The level of transaction costs

Macroeconomics Chapter 1017 The Demand for Money  The Money-Demand Function M d = P · L(Y, i) M d /P = L( Y, i)

Macroeconomics Chapter 1018 The Demand for Money  Empirical Evidence on the Demand for Money Steven Goldfeld Casey Mulligan and Xavier Sala-i- Martin Michael Dotsey

Macroeconomics Chapter 1019 Determination of the Price Level  The Nominal Quantity of Money Supplied Equals the Nominal Quantity Demanded  M s = M d  M d = P · L( Y, i)  Key equation: M s = P · L( Y, i)

Macroeconomics Chapter 1020 Determination of the Price Level  General equilibrium.  M s = M d  L s = L d  (κK) s = (κK) d.

Macroeconomics Chapter 1021 Determination of the Price Level

Macroeconomics Chapter 1022 Determination of the Price Level  A Change in the Nominal Quantity of Money From a one-time change in the nominal quantity of money supplied,M s. The increase in M s from M to 2M raises the equilibrium price level from P ∗ to 2P ∗

Macroeconomics Chapter 1023 Determination of the Price Level

Macroeconomics Chapter 1024 Determination of the Price Level  A Change in the Nominal Quantity of Money Since the technology level, A, has not changed, the real wage rate, w/P, and labor input, L, do not change. Therefore, the price level, P, is twice as high, and w/P is unchanged. We conclude that, in general equilibrium, the nominal wage rate, w, has to double.

Macroeconomics Chapter 1025 Determination of the Price Level  A Change in the Nominal Quantity of Money The unchanged technology level, A, means that the real rental price, R/P, and the quantity of capital services, κK, do not change. The fixed κK corresponds to a given capital stock, K, and an unchanged capital utilization rate, κ. Thus, the price level, P, is twice as high, and R/P is unchanged. We must have, in general equilibrium, that the nominal rental price, R, doubles.

Macroeconomics Chapter 1026 Determination of the Price Level  A Change in the Nominal Quantity of Money i = (R/P) · κ − δ(κ).  The doubling of M s does not change the real rental price, R/P, and the capital utilization rate, κ, the rate of return on ownership of capital does not change on the right hand side of equation  The interest rate, i, is also unchanged

Macroeconomics Chapter 1027 Determination of the Price Level  A Change in the Nominal Quantity of Money Y= A · F(κ K, L) A doubling of M s does not affect the quantities of capital services, κK, and labor, L. In other words, in general equilibrium, a one-time increase in the nominal quantity of money supplied, M s, does not affect real GDP.

Macroeconomics Chapter 1028 Determination of the Price Level  The Neutrality of Money In the long run, an increase or decrease in the nominal quantity of money supplied, M s, influences nominal variables but not real ones.

Macroeconomics Chapter 1029 Determination of the Price Level  A Change in the Demand for Money An improvement in the technology for making financial transactions — perhaps increased use of credit cards or ATM machines — decreases the real demand for money to [L(Y, i) ’ ], so that the nominal demand becomes: ( M d ) ’ = P · [ L( Y, i) ’ ]

Macroeconomics Chapter 1030 Determination of the Price Level

Macroeconomics Chapter 1031 Determination of the Price Level  A Change in the Demand for Money A decrease in the real demand for money is similar to an increase in the nominal quantity Of money supplied in that the price level, P, rises in each case. However, one difference is that a change in M s is fully neutral, whereas a change in the real demand for money is not fully neutral.

Macroeconomics Chapter 1032 Determination of the Price Level  The Cyclical Behavior of the Price Level A recession,  decline in Y reduces the real quantity of money demanded  The decrease in i raises the real quantity of money demanded In a recession, the real quantity of money demanded, given by L(Y, i), decreases overall.

Macroeconomics Chapter 1033 Determination of the Price Level  The Cyclical Behavior of the Price Level Given nominal quantity of money supplied, M s, the decrease in the real quantity of money demanded, L(Y, i), raises the price level, P. That is P will be countercyclical.

Macroeconomics Chapter 1034 Determination of the Price Level

Macroeconomics Chapter 1035 Determination of the Price Level  The Cyclical Behavior of the Price Level In our equilibrium business cycle model, the underlying shocks come from the supply side, not the demand side. A low technology level, A — the source of a recession in the model — means that goods and services are in low supply. When looked at this way, it makes sense that P would tend to be high in a recession.

Macroeconomics Chapter 1036 Determination of the Price Level  Price-Level Targeting and Endogenous Money When the monetary authority seeks to attain a specified price level, P, it typically has to adjust the nominal quantity of money, M, in response to changes in the nominal quantity demanded, M d.

Macroeconomics Chapter 1037 Determination of the Price Level  Price-Level Targeting and Endogenous Money To see how this works, we now assume that the monetary authority wants the price level, P to equal a target level P 0. This objective is called price-level targeting.

Macroeconomics Chapter 1038 Determination of the Price Level  Price-Level Targeting and Endogenous Money M = P 0 · L( Y, i )  nominal quantity of money = price-level target · real quantity of money demanded

Macroeconomics Chapter 1039 Determination of the Price Level  Price-Level Targeting and Endogenous Money Trend growth of money  Since L(Y, i) grows at the same rate as real GDP, Y, we conclude that M must grow at the same rate as Y. Thereby, the growth rate of the nominal quantity of money, M, matches the growth rate of the real quantity demanded, L(Y, i), and allows the price level, P, to remain constant at its target level, P 0.

Macroeconomics Chapter 1040 Determination of the Price Level  Price-Level Targeting and Endogenous Money Cyclical behavior of money The cyclical fluctuations in M will match the cyclical fluctuations in the real quantity of money demanded. M should be procyclical.  Empirically, the nominal quantity of money, M, is weakly procyclical.

Macroeconomics Chapter 1041 Determination of the Price Level  Price-Level Targeting and Endogenous Money Seasonal variations in money  Monetary authority has to vary the nominal quantity of money, M, to match the changes in the real quantity demanded, L(Y, i), that occur because of economic growth or fluctuations.  An analogous argument applies to the variations in L(Y, i) associated with the seasons.