Lecture 4_Money

Lecture Overview

• Lecture 4 Focus: Financial Markets

• Reading Assignment: Blanchard, Chapter 4 (excluding section 4.3)

Recap: Previous Lecture Points

• Keynesian Cross Concepts:

  • Determining equilibrium output based on investment (𝐼), taxes (𝑇), government spending (𝐺), and consumption parameters (𝑐0, 𝑐1).

  • Changes in consumption parameters (𝑐0, 𝑐1) impact equilibrium output.

  • Basic principles of government expenditure and taxation.

Review of Investment Effects

• Investment Increase Impact:

  • Aggregate Demand Formula:‣ 𝑍 = 𝑐0 + 𝑐1𝑌 − 𝑇 + 𝐼 + 𝐺

  • 𝑌 (Supply) equals total output.

  • If 𝐼 (investment) increases by Δ𝐼, then:‣ 𝑌 = 1/(1−𝑐1)(𝑐0 + 𝐼 + 𝐺 − 𝑐1𝑇) leads to changes in 𝑌:‣ Δ𝑌 = 1/(1 − 𝑐1)Δ𝐼

Outline of Current Lecture

• Topics Covered:

  • Money Supply and Open Market Operations

  • Money Demand

  • Equilibrium Interest Rate

  • Liquidity Trap

Objectives

• Introduce concepts of money, bonds, and interest rates.

• Understand how central bank policy affects money supply and interest rates.

• Discuss factors affecting money demand.

• Explain the liquidity trap and the zero lower bound.

Understanding Money

• Liquidity Definition:

  • A financial asset is considered liquid if it can be quickly used for transactions.

  • Forms of Money:

    • Legal tender (notes, coins) + Checkable deposits.

    • Most liquid assets that can be used in transactions.

  • Different Measures:

    • M1 (most liquid) vs M2 (includes less liquid assets).

Money's Role in Economic History

• The Great Depression Analysis:

  • Real GDP declined from 1,109 to 817 between 1929-1933 (30% loss).

  • Key Insight: Credit and monetary stability in the economy relate closely to growth and stability.

The Great Contraction Context

• Friedman and Schwartz Analysis:

  • The significant decline in the money supply was a major contributor to the Great Depression.

  • Examining impacts of money supply changes on economic performance.

Central Bank Operations

• Open Market Operations:

  • Central banks adjust money supply (𝑀𝑆) by buying/selling government bonds.

  • Expansionary Policy: Buy bonds to increase 𝑀𝑆.

  • Contractionary Policy: Sell bonds to decrease 𝑀𝑆.

Financial Assets Comparison

• Determinants for Asset Allocation:

  • People choose between holding money and financial assets (like bonds).

  • Money demand depends on transaction needs versus interest rates.

Types of Bonds and Returns

• Types of Financial Assets:

  • Focusing on one-year, zero-coupon, risk-free government bonds for simplicity.

  • Return Calculation Example:

    • 𝑖 = ($100 - $𝑃𝐵)/$𝑃𝐵 measures bond returns and their inverse relationship with bond prices.

Demand for Money Dynamics

• Motives for Holding Money vs Bonds:

  • Money for liquidity and transactions; bonds for positive interest.

  • Money demand (𝑀𝐷) is a function of transaction needs and interest rates.

Quantity Theory of Money

• Equation:

  • 𝑀𝑉 = $𝑌, where 𝑉 (velocity) reflects how frequently money circulates.

  • Increase in velocity attributed to technological advancements.

Market Equilibrium

• Supply and Demand for Money:

  • 𝑀𝑆 determined by central banks.

  • Equilibrium occurs when money demand equals money supply.

Effects of Money Supply Changes

• Interest Rate Implications of Increased 𝑀𝑆:

  • Higher money supply typically leads to lowered equilibrium interest rates.

  • Bond Market Correlation: An increase in money supply affects bond demand/price consistency.

Examining the Liquidity Trap

• Understanding the Trap:

  • When interest rates drop below zero, bonds lose attractiveness.

  • People are indifferent in holding money versus bonds at zero interest.

Real-World Application of ZLB

• Central Bank Interest Rate Trends:

  • Examination of real-world rates compared against historical records.

Summary of Key Insights

• Interest rates are influenced by money supply and demand.

• Central banks manage money supply through open market operations to steer interest rates.

• Effective policy aims for maximum employment and inflation stabilization, with current rates in range.

Next Class Preview

• Incorporation of interest rates into the Keynesian cross, leading to development of the IS-LM model.

• Read: Blanchard, Chapter 5 for future discussions.