M = the money supply P = price level Y= aggregate output (income) P x Y = aggregate nominal income (nominal GDP) V= velocity of money (average number of times per year that a dollar is spent) Velocity fairly constant in short run Aggregate output at full-employment level Changes in money supply affect only the price level Movement in the price level results solely from change in the quantity of money
Trang 1
Chapter 21
The Demand for Money
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Trang 2-Velocity of Money and Equation of Exchange
M =the money supply
P = price level
Y= aggregate output (income)
P x Y = aggregate nominal income (nominal GDP)
V= velocity of money (average number of times per year
that a dollar is spent)
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Trang 324-Quantity Theory of Money
® Velocity fairly constant in short run
° Aggregate output at full-employment level
® Changes In money supply affect only
the price level
¢ Movement in the price level results solely
from change In the quantity of money
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Trang 4Quantity Theory of Money Demand
Divide both sides by V
M= (1/V) x PY
When the money market Is in equilibrium M = Ma
Let k = 1/V
Md = k x PY
® Because kK is constant, the level of transactions
generated by a fixed level of PY determines the quantity
of Md
¢ The demand for money ts not affected by interest rates
Trang 5ls Velocity a Constant?
4-—
3L 2k +1l_—
O + -4-} } ee 4 - - - - Me -L- -\ 9 - - a - - + 4 -} - -—-1
—2 +
3 ị
al fl
—B |—
—6 |—
—7 |—
—8 LLLLL_] | | J LL L L L1 | | jf LL L | L | | L | L L TL L ]
Con vr OF DON FT OF DW CC A TFT Oo ƠœŒƠ CC C(GI x CO WD
SSS5S555 F658 R38 FRGSEGSEKSESESESESESES SBS
ee re eee ee ee QIl 9 GI
FIGURE 21-1 Change inthe Velocity of M2++ (gross), 1968-2008
Shaded areas indicate recessions
Source: Statistics Canada CANSIM II series V41552801, V41707150, and V1997756
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Trang 6Keynes's Liquidity Preference Theory
® Transactions Motive
- Positively related to Income
® Precautionary Motive
- Positively related to Income
® Speculative Motive
- Negatively related to interest rate
® Distinguishes between real and nominal
quantities of money
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Trang 724-The Three Motives |
M°
5 =f (iY)
Rewriting
P.1
M°_ f(i,Y)
Multiple both sides by Y and replace Md with M
_PY _ Y
—M_ f(VY)
V
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Trang 8The Three Motives II
© Pro-cyclical movements in interest rates should induce pro-cyclical movements In velocity
® Velocity will change as expectations about future nominal levels of interest rates change
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Trang 9Further Developments in the Keynesian
Approach
Transactions Demand
® Baumol - Tobin approach theorized money balances
held for transactions purposes are sensitive to interest
rates
¢ There Is an opportunity cost and benefit
to holding money
° The transaction component of the demand for money Is negatively related to the level of interest rates
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Trang 10Cash Balances In the Baumol-Tobin Model
Cash Cash
($) ($)
500 0 1 2
FIGURE 21-2 Cash Balances in the Baumol-Tobin Model
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Trang 11Precautionary Demand
® Similar to transactions demand
© As interest rates rise, the opportunity cost of
holding precautionary balances rises
° The precautionary demand for money Is
negatively related to interest rates
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Trang 12Speculative Demand
very little diversification
- People held wealth as either money or bonds but rarely both
© Only partial explanations developed further
- Risk averse people will diversify
- Did not explain why money Is held as a store of
wealth
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Trang 13Friedman’s Modern Quantity Theory of Money
M4/P = f(Ys, ro - Fm, Fe - Fm , 7e - Fm )
where:
M4/P = demand for real money balances
Y, = permanent income (measure of wealth) f„= expected return on money
r, = expected return on bonds
r = expected return on equities
me = expected return on equities
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Trang 14Variables in the Money Demand Function
¢ Permanent income (average long-run income) is
stable, the demand for money will not fluctuate
much with business cycle movements
© Wealth can be held in bonds, equity and goods;
incentives for holding these are represented by the
expected return on each of these assets relative to
the expected return on money
® The expected return on money is influenced by:
- The services provided by banks on deposits
- The interest payment on money balances
Trang 15Differences Between Keynes’s and Friedman's
Model |
° Friedman
- Includes alternative assets to money
- Viewed money and goods as substitutes
- The expected return on money Is not constant;
however, ', - ,,does stay constant as interest rates
rise
—- Interest rates have little effect on the demand for
money
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Trang 16Differences Between Keynes’s and Friedman's
Model I
© Permanent income is the primary determinant of
money demand
M4/P = f( Y,)
© Velocity of money Is predictable since relationship
between Y and Y, is predictable
V =Y/ f( Y,)
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Trang 17Empirical Evidence on the Demand for
Money
® Interest rates and money demand
- Consistent evidence of the interest sensitivity of the demand for money
- Little evidence of liquidity trap
© Stability of money demand
- Prior to 1970, evidence strongly supported stability of the
money demand function
- Since 1973, instability of the money demand function has
caused velocity to be harder to predict
© Implications for how monetary policy should be
conducted
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