Monetary Theory & Policy:
Chapter 20:
The quantitiy theory of money: explains how the nominal value of the national income is
developed -> suggest that interest rates have no effect on the demand of money.
Velocity of money: V = PxY/M = price level x aggregrate output (income) / money supply
Equation of exchange = M x V = P x Y
Tells us that the quantity of money x velocity of money gives us the nominal GDP.
Short run: We assume that the velocity of money (V) is constant in the short run
We can use the short run assumption to calculate the money demand:
Step 1: divide both sides by V -> M = 1/V x PY k = 1/V
Step 2: if the money market is in equilibrium -> M = Md
Step 3: Md = k x PY
We now see that the money demand is not affected by interest rates and since k is a
constant the level of transactions is generated by a fixed level op PY (nominal GDP)
Short run: We also assume that the aggregrate output (Y) is constant in the short run since in
normal times the output produced would remain at the full – employment level.
Since now V and Y are both assumed to be a constant, we can come up with a formula that
gives us the price level:
P = M x V(constant) / Y(constant)
This tells us that only changes in the quantity of money lead to proportional changes
in the price level.
Inflation = Pi = %∆M - %∆Y (works in the long run but not in the short run)
Two ways can pay for its budget deficits:
1. Raise revenue by raising taxes
2. Borrow by issuing government bonds
3. Print money
Budget constraint: DEF (budget deficit) = G – T = ∆MB + ∆B
MB = monetary base (how much money in the economy)
B = Government bonds
, Keynesian Theories of Money Demand
Liquidity preference theory: Why do individuals hold money:
Three motives:
1. Transactions motive: people hold money to wait for innovations
2. Precautionary motive: people hold money just in case
3. Speculative motive: keeping money as a store of wealth
Liquidity preference function:
V = PY/M = Y/f(I,Y) where i = interest rate
This is a contradiction to the theory of quantity of money
Stability of money demand:
V = PY/M = Y/f(I,Y)
The more sensitive the demand for money is to i, the more unstable is V
Instability of money demand function and the predictability of V
Monetary policy: targeting interest rates or money supply -> by looking at the stability
of demand central banks know whether to target the interest rates or the money
supply.
Chapter 24:
Aggregrate demand: Y = C + I + G + NX
Short run aggregrate supply: pi = pi (expected) + a(Yactual – Ypotential) + p(inflation shocks)
Long run aggregrate supply: Yp
Three types of shocks:
1. Aggregrate demand shock
2. Permanent supply shock
3. Temporary supply shock
Response of Monetary policy to shocks:
- Price stability (minimize inflation)
- Economic stability (minimize the output gap)
Central bank has two options: (aggregate demand shock)
1. No policy response (let the economy recover itself)
2. Policy response (stabilizing output and inflation in the short run by changing the
interest rates
Chapter 20:
The quantitiy theory of money: explains how the nominal value of the national income is
developed -> suggest that interest rates have no effect on the demand of money.
Velocity of money: V = PxY/M = price level x aggregrate output (income) / money supply
Equation of exchange = M x V = P x Y
Tells us that the quantity of money x velocity of money gives us the nominal GDP.
Short run: We assume that the velocity of money (V) is constant in the short run
We can use the short run assumption to calculate the money demand:
Step 1: divide both sides by V -> M = 1/V x PY k = 1/V
Step 2: if the money market is in equilibrium -> M = Md
Step 3: Md = k x PY
We now see that the money demand is not affected by interest rates and since k is a
constant the level of transactions is generated by a fixed level op PY (nominal GDP)
Short run: We also assume that the aggregrate output (Y) is constant in the short run since in
normal times the output produced would remain at the full – employment level.
Since now V and Y are both assumed to be a constant, we can come up with a formula that
gives us the price level:
P = M x V(constant) / Y(constant)
This tells us that only changes in the quantity of money lead to proportional changes
in the price level.
Inflation = Pi = %∆M - %∆Y (works in the long run but not in the short run)
Two ways can pay for its budget deficits:
1. Raise revenue by raising taxes
2. Borrow by issuing government bonds
3. Print money
Budget constraint: DEF (budget deficit) = G – T = ∆MB + ∆B
MB = monetary base (how much money in the economy)
B = Government bonds
, Keynesian Theories of Money Demand
Liquidity preference theory: Why do individuals hold money:
Three motives:
1. Transactions motive: people hold money to wait for innovations
2. Precautionary motive: people hold money just in case
3. Speculative motive: keeping money as a store of wealth
Liquidity preference function:
V = PY/M = Y/f(I,Y) where i = interest rate
This is a contradiction to the theory of quantity of money
Stability of money demand:
V = PY/M = Y/f(I,Y)
The more sensitive the demand for money is to i, the more unstable is V
Instability of money demand function and the predictability of V
Monetary policy: targeting interest rates or money supply -> by looking at the stability
of demand central banks know whether to target the interest rates or the money
supply.
Chapter 24:
Aggregrate demand: Y = C + I + G + NX
Short run aggregrate supply: pi = pi (expected) + a(Yactual – Ypotential) + p(inflation shocks)
Long run aggregrate supply: Yp
Three types of shocks:
1. Aggregrate demand shock
2. Permanent supply shock
3. Temporary supply shock
Response of Monetary policy to shocks:
- Price stability (minimize inflation)
- Economic stability (minimize the output gap)
Central bank has two options: (aggregate demand shock)
1. No policy response (let the economy recover itself)
2. Policy response (stabilizing output and inflation in the short run by changing the
interest rates
