MoneyDemandFunction

4.2 :

,
4.2 showsthatforanygivenexpectedrateofinflation
,

increases thenominalinterest
anincrease intherealinterestrate
rate andsoreduces thedemandformoney.
Similarly,foranygivenrealinterestrate ,anincrease inthe
expectedrateofinflation
increases thenominalinterestrate
andsoreduces thedemandformoney.
Rememberthat thenominalinterestrate movesoneforone with
changesinexpectedinflation
.

RealMoneyBalances
Sincethedemandfornominalmoneyisproportional tothe
aggregate(oroverall)pricelevel ,wecandividebothsidesof
nominalmoneydemandequationby :

4.3

RealMoneyBalances

4.3 givestheliquidity demand function orthedemandforreal

balancesfunction.Thelefthandsideof
4.3 isthedemand for
real balances (therealpurchasing power ofmoneyortheamountof
moneydemandedintermsofthegoods itcanbuy).
Therighthandsideof
4.3 istheliquidity demand function.
Thedemandforrealmoneybalancesisdecomposedintoa
transaction demandformoney(capturedby )andaportfolio
demandformoney(capturedby and ).

OtherFactorsAffectingMoneyDemand
Changesinvariablesotherthantheinterest rate causethedemand
curvetoshift.
Wealth:anincrease inwealthcausesmoneydemandtorise
becausepartofanincreaseinwealthmaybeheldintheformof
money.
Risk:anincrease inriskofalternativeassetscausesmoneydemand
torise sincehigher riskofalternativeassetsmakesmoneymore
attractive.Ontheotherhand,anincrease inriskofmoneycauses
moneydemandtofall becausehigher riskofmoneymakesitless
attractive.

OtherFactorsAffectingMoneyDemand
Forexample,inaperiodoferraticinflation,peopletrytoswitch
moneytoinflationhedges(assetswhoserealreturnsarelesslikelyto
beaffectedbyerraticinflation)suchasgold,realestate,and
consumerdurablegoods.
Liquidity ofalternativeassets:anincrease inliquidityofalternative
assetscausesmoneydemandtofall sincehigher liquidityof
alternativeassetsmakestheseassetsmore attractive.

OtherFactorsAffectingMoneyDemand
Efficiency ofpaymenttechnology:anincrease inpayment
technologycausesdemandmoneytofall sincepeoplecanoperate
withless money.
Expected inflation:anincrease inexpectedinflationcausesmoney
demandtofall sincehigher expectedinflationmeansahigher return
onalternativeassetsandthusswitchawayfrommoney.

DeterminingtheInterestRate

:MethodI

Q:Bywhatisthemoneysupplyaffected?
A:
(i)Thecentralbank (theFederalReserveSystem,justcalledthe
Fed,intheUnitedStates)isthegovernmentinstitutionresponsiblefor
monetarypolicies.
(ii)Depositoryinstitutions areprivatelyownedbanksandthrift
institutions(suchassavingsandloanassociation)thataccept
deposits fromandmakeloans directlytothepublic.
(iii)Thepublic includeseverypersonorfirm(exceptbanks)thatholds
moneyincurrency ordeposits.

AssetMarketEquilibrium
Assumption:Allassetscanbegroupedintotwocategories,money

andbonds ornonmonetary assets

.

4.4 :

=aggregatenominalwealth
4.5 :

aggregatenominalwealth

If

4.6 :

0
0,

mustbezero.

AssetMarketEquilibrium
Thatis,iftheamountsofmoneysuppliedanddemandedare
equal,theamountsofnonmonetaryassetssuppliedand
demandedalsomustbeequal.
Theentireassetmarketisinequilibrium ifthequantityof
moneysupplied equalsthequantityofmoneydemanded.
Itmeansthatthatinstudyingassetmarketequilibriumwe
havetolookatonlythesupplyanddemandformoneyand
canignorenonmonetaryassets.

,M,andtheEquilibriumInterestRate
Intherealworld,therearetwotypesofmoneyinM1:checkable
deposits (suppliedbybanks)andcurrency (suppliedbythecentral
bank).
Assumption inMethodI:Onlymoneyintheeconomyiscurrency in
circulation,thatis,thequantityofmoneyisthenumberofdollars
heldbythepublic.
Wefirstlookatinterestrateusingthemoney marketmodel (also
calledtheliquidity preference model).

, ,andtheEquilibriumInterestRate
Themoneymarketmodelfocusesonhowtheinteractionofthe
demandandsupplyformoneydeterminestheshortterm (theloan
orbondwillmature,orbepaidoff,inoneyearorless)interestrate.

Supposethecentralbankdecidestosupplyamountsofmoneyequal
, theamountofmoneyavailableinaneconomy
toM,so
(moneystockormoneysupply).
Moneymarketequilibriumcondition:

,
,

, ,andtheEquilibriumInterestRate
Exogenousvariables:P,M and
Endogenousvariables:Yand r
Eq(4.7)iscalledtheLM relation.
TheletterL standsforliquidity ameasureofhoweasilyanassetcan
beexchangedformoney.
TheletterM standsformoney.
Inequilibrium,thedemandforliquidity mustequalthesupplyof
money.

Figure 4.2:TheDeterminationofInterestRate

TheDeterminationofInterestRate
Thesupplyofmoney(M)isassumedtobefixed themoneysupply
M isanexogenous policyvariablechosenbyacentral bank:
thecentralbankisabletosetthesupplyofmoneyatwhateverlevel
itchooses.
Inotherwords,themoneysupply(M)isindependent oftheinterest
rate;i.e.themoneysupplycurveisavertical line,andchangesinthe
interestratehavenoeffectonthequantityofmoneysupplied.
ThepricelevelP isalsoanexogenous variablebecauseweassume
thatthepricelevelisfixed intheshortrun.

TheDeterminationofInterestRate
Accordingtothetheoryofliquidity balances,thesupplyanddemand
formoneybalancesdeterminewhatinterest rate prevailsinthe
economy.Thatis,theinterest rate adjuststoequilibratethemoney
market.

Figure 4.3:TheEffectsofanIncreaseinNominalIncomeonthe
InterestRate

Anincrease innominalincomeleadstoanincrease intheinterestrate.

How?

EffectofanIncreaseinNominalIncomeontheInterestRate
Nominalincomeincreasesfrom$ to$
Themoneydemandcurveshiftsrightward from
to
:
Atthe initial interest , thedemandformoneyexceeds thesupply
ofmoney
Agents(householdsorfirms)haveless moneythantheywantto
holdatan initial interestrate : shortage (or excess demand for)of
money

EffectofanIncreaseinNominalIncomeontheInterestRate
Q:Whatdoagentsdowiththeshortageofmoney?
Theyaremostlikelytosell shorttermbonds
Sellingshorttermassetssuchasbondsdrivesdown theirprices
anddriveup theirinterestrates.Thatis,anincrease intheinterest
rateisneededtodecrease theamountofmoneypeoplewanttohold
andtoreestablishequilibrium
Themoneymarketachievesanewequilibriumat

ShiftsofMoneySupply&MoneyDemand
Whatshiftsnominalmoneysupply:

Whatshiftsnominalmoneydemand:
, ,
Whatshiftsrealmoneysupply:
,
Whatshiftsrealmoneydemand:
,

MonetaryPolicyandOpenMarketOperations
Openmarketoperations
Purchases orsales ofgovernmentsecuritiesbythecentralbankin
theopenmarketforbondstochangethesupply ofmoney
Expansionaryopenmarketoperation:purchases ofgovernment
securities(governmentbonds)bythecentralbanktoincrease
(expand)themoneysupply
Contractionaryopenmarketoperation:salesofgovernment
securitiesbythecentralbanktodecrease (contract)themoney
supply

MonetaryPolicyandOpenMarketOperations
Openmarketpurchasesinwhichthecentralbankincreases the
moneysupplybybuying bondsleadtoanincrease inthepriceof
bondsandadecrease intheinterestrate.
Thepurchase ofbondsbythecentralbankshiftsthemoneysupply
totheright.
Openmarketsalesinwhichthecentralbankdecreases themoney
supplybyselling bondsleadtoadecrease inthepriceofbondsand
anincrease intheinterestrate.
Theselling ofbondsbythecentralbankshiftsthemoneysupplyto
theleft.

Figure 4.4:TheEffectofanIncreaseintheMoneySupplyonthe
InterestRate

EffectofanIncreaseintheMoneySupplyontheInterestRate
Anincrease inthesupplyofmoneybythecentralbankleadstoa
decrease intheinterestrate.
How?
Thecentralbankincreases themoneysupply:themoneysupply
curveshiftsrightward from
to
.
Agents(householdsorfirms)havemore moneythantheywantto
holdatan initial interestrate :surplus (orexcess supply)ofmoney

EffectofanIncreaseintheMoneySupplyontheInterestRate
Q:Whatdoagentsdowiththeextramoney?
Theyaremostlikelytousethemoneytobuy shorttermbonds
Buyingshorttermassetssuchasbondsdrivesup theirpricesand
drivedown theirinterestrates
Thedecrease intheinterestrateincreases thequantitydemanded
ofmoneysoitequalsthenowlargermoneysupply
Themoneymarketachievesanewequilibriumat

QuantitativeEasing(QE)
http://www.telegraph.co.uk/finance/economics/11361414/Economic
sexplainerwhatisQE.html
https://www.youtube.com/watch?v=J9wRq6C2fgo

Example(4.1):MoneyMarketEquilibrium
Supposethatmoneydemandisgivenby
$ 0.25
is$100.Also,supposethatthesupplyofmoneyis$20.
a)Whatistheequilibriuminterestrate?
(Ans.)
Equilibriumcondition:
$20 $100 0.25
$20 $25 $100
$100
$5

0.05 5%

where$Y

Example(4.1):MoneyMarketEquilibrium
b)IftheFederalReserveBankwantstoincreasei by10percentpoints
(e.g.,from2%to12%),atwhatlevelshoulditsetthesupplyofmoney?
(Ans.)

$100 0.25 0.15

$100 0.1 $10.

Example (4.2):MoneyMarketEquilibrium
Supposethatthemoneydemandfunctionis
1000 100 ,
where istheinterestrateinpercent.Themoneysupply is1000
andthepricelevel is2.
a)Whatistheequilibriuminterestrate?
(Ans.)
Equilibriumcondition:

500

1000

100

1000
5%.

100

Example (4.2):MoneyMarketEquilibrium
b)Assumethatthepricelevelisfixed.Whathappenstothe
equilibriuminterestrateifthesupplyofmoneyisraisedfrom1,000to
1,200?
(Ans.)
Equilibriumcondition:

600

1000

100

1000

100

4%.

Thus,increasingthemoneysupplyfrom1,000to1,200causesthe
equilibriuminterestratetofall.

Example (4.2):MoneyMarketEquilibrium
d)IftheFedwishestoraisetheinterestrateto7%,whatmoneysupply
shoulditset?
(Ans.)
Set

1000

100