KOM: Chapter 15

What are 3 roles in which money plays?

1. As a Medium of exchange; you don’t have to barter

2. As a Unit of account; we measure value in money

3. As a Store of value; we can transfer purchasing power into the future with it

Money supply

The monetary aggregate the Federal Reserve calls M1, that is, the total amount of currency and checking deposits held by households and firms

The central bank controls the money supply directly and indirectly

What are the 3 characteristics that individuals base their demand on assets for? (Remember currency is an asset)

1. The expected return the asset offers compared with the returns offered by other assets.

2. The riskiness of the asset’s expected return.

3. The asset’s liquidity.

A rise in the interest rate cause the demand for money to ____

FALL!

There is no interest on currency and checking deposits give very low. Other forms of illiquid assets provide more interest and thus greater rates of return. When the interest rate is higher you are losing out even more by not holding those assets by holding money.

Why is risk not an important factor in money demand?

The risk of holding money is that an increase in the price level can cause that money to be worth less. However other assets like bonds are also priced in money, and so will also decrease in value. Therefore you don’t need to worry about it

A rise in the average value of transactions that a household or firm carries out causes its demand for money to _____.

RISE!

Some larger transactions can financed through selling an illiquid asset. But the main benefit of money is its liquidity. Therefore daily purchases will be financed that way. Greater daily purchase, greater demand for money.

What are the 3 main factors determining aggregate money demand?

1. The interest rate. Demand falls when interest rate rises.

2. The price level. If households when to maintain the same level of liquidity, when price level increases so must their holdings of money.

3. Real national income. When GNP rises more goods are transacted so the demand for money increases.

What is the aggregate money demand relation equation?

(Hint: It is derived from the 3 main factors affect aggregate money demand)

M^d is the aggregate demand for money,

P is the price level, R is the interest rate, and Y is real GNP

L(R,Y) is called aggregate REAL money demand and as you can see it is the demand to hold a certain ratio of real purchasing power in liquid form

L(R,Y) has an inverse relationship with R but direct with Y

When is the interest rate at equilibrium?

When M^s = M^d (so when the money supply equals the money demand)

With some algebraic rearrangement you can also get the condition as

M^s/P = L (R,Y)

What is the mechanism for the interest rate to return to equilibrium if it is above/below it?

If it is above then there an excess supply of money as everyone wants to sell for high-interest illiquid assets. Because not everyone will be able to purchase them outright, they will entice the sale by offering lower interest rates. This creates downwards pressure that drops the interest rate back to EQ.

Inversely there is a excess demand for money and everyone ones to sell their assets and borrow in order to get that money. Since not everyone can get the money those who really want it will offer higher interest rates on their borrowing to get it. This upward pressure brings up the interest back to EQ.

An increase in the money supply ______ the interest rate, while a fall in the money supply _______ the interest rate, given the price level and output.

Lowers and raises. So the interest rate and money supply move in opposite directions.

An increase in real output ____ the interest rate, while a fall in real output _____ the interest rate, given the price level and the money supply.

Raises and lowers. Real output and interest rate move in same direction.

An increase in a country’s money supply causes its currency to _____ in the foreign exchange market, while a reduction in the money supply causes its currency to _______.

Depreciate and appreciate. They move in opposite directions.

Fact: In the simultaneous US money market and foreign exchange market the US interest rate is the connecting factor. US interest rate feeds into foreign exchange market model

Also, there will be two equilibria in this two part model: equilibrium Interest rate and equilibrium exchange rate

T/F: An increase in European money supply will cause a fall in Euro interest rates directly AND a fall in US interest rates through the money market

FALSE; What the the interest rates and money supply happens abroad has ZERO effect on the interest rate at home, only the exchange rate.

Long-run equilibrium

The situation that an economy will eventually reach if no new economic shocks occur during adjustment to full employment.

It is the EQ if prices were perfectly and immediately flexible to preserve full employment

Fact: You can rearrange the market equilibrium equation to

P = M^s / L(R,Y)

You can use this equation to find the long-run EQ price as long as the interest rate and output are also at their long-run levels

A permanent increase in the money supply will cause a proportional increase in the long-run price level.

T/F: A change in the money supply has no effect on long-run interest rates or real output (R and Y)

True!

Real output is based on factor endowments like labor and capital so it doesn’t change with money supply.

Interest rates won’t change because percents factor in the increase in money supply already

Will a permanent increase in a country’s money supply cause a proportional long-run appreciation or depreciation of its currency against foreign ones? How about domestic relative prices?

Depreciation and relative prices wouldn’t change since the ratio would be the same

We have assumed that price levels, unlike the exchange rate, are fixed in the short-run. Is this a good assumption to make?

Yes. Some products, like agriculture, have their price levels change everyday and other products require imported inputs who prices are changed quickly by exchange rates. BUT, wages tend to be sticky and their costs are a significant portion of production costs. So price levels are themselves sticky in the short-run.

THIS DOES NOT APPLY TO HIGH INFLATIONARY SCENARIOS; there price levels will change quickly due to extreme conditions

What are the 3 sources of inflationary pressure from an increase in money supply?

1. Excess demand for output and labor. Increase in money supply is expansionary so producers make workers work overtime, hire more, and willing to accept asks of higher wages in the next period because they know they can easily pass it to consumers in a booming economy

2. Inflationary expectations. If everyone expects inflation in the future then workers will demand higher wages now to protect their real wages. Producers will give in if they expect product prices to really rise and cover the cost.

3. Raw materials prices. The prices of paw materials do adjust sharply even in the short-run. To cover production costs firms will have to raise their own prices.

Why is the dollar depreciation greater when there is a permanent money supply increase rather than a temporary one?

When the change is seen as permanent people expect the future dollar prices of everything to increase, including of foreign currencies, which is a expected depreciation of the dollar.

Remember that dollar returns on euros is euro interest rate + depreciation of the dollar, so this expected depreciation shifts the expected euro return to the right.

So the dollar depreciates by BOTH having lower interest rates and increasing the expected euro return. If the change was temporary it would only depreciate by the lower interest rate.

In the long-run, will the dollar appreciate or deprecate when adjusting for a money supply increase?

In the short-run the interest will drop, but as the price level adjusts, the interest will rise back to the original level. Higher interest rate means the currency will appreciate, although not enough to return it to its pre-money supply increase level (the short-run exchange rate overshoots the long-run)

Why must short-run exchange rate overshoot it’s long-run value?

The short-run drop in dollar interest rates will unbalance the interest parity condition as the euro has greater returns now. In order to balance things out the dollar must appreciate over time as to reduce euro returns until the price-level fully adjusts.

If price levels weren’t rigid in the short-run there would be no need for overshooting to keep this balance. It would immediately go to its long-run level.

Why does unexpectedly high inflation lead to currency appreciation? (as opposed to currency depreciation as our model has earlier said)

Central banks actually focus on controlling the interest rates rather than the money supply. This means the money supply can adjust via market forces. They will also adjust interest rates so as to keep inflation in check.

So if inflation is higher than expected then the central bank will raise interest rates to keep reduce the money supply and combat this inflation. Raising the interest rates causes the currency to appreciate immediately.

This effect is stronger for core inflation than headline, and for inflation-targeting countries than those that don’t.

Velocity of money (V)

V =Y/(M/P)

In words, the ratio of real GNP to real money holdings