Understanding Real and Nominal Money Markets

Transitioning from Real to Nominal Money Market

• Overview: The video explains how to navigate between the real and nominal money markets, emphasizing that they are fundamentally the same but represented through different variables.

• Real Money Market:

  • In the real money market, we analyze the relationship using the graph of real money supply and demand.

  • Variables:

  • Real Money Supply: Represented as m (little m), calculated as nominal money supply over the price level ( ext{Real Money Supply} = rac{ ext{Nominal Money Supply}}{ ext{Price Level}}).

  • Real Money Demand: This is downward sloping, typically a function of interest rates and real GDP.

  • Interest Rate Determination: The equilibrium between real money supply and demand determines the nominal interest rate within this framework. Instead of showing actual quantities permitted, we denote it using little m for simplicity.

• Nominal Money Market:

  • When transitioning to the nominal money market, the same graph structure is retained but now involves the nominal money supply and demand (represented as M and ext{Money Demand} respectively).

  • Notice:

  • The nominal supply M is aligned with nominal demand, both yielding the same nominal interest rate.

  • Conversion occurs as the real money supply ext{m} is multiplied by the price level to become nominal: ext{Nominal Money Supply} = ext{Real Money Supply} imes ext{Price Level}.

• Converting Variables:

  • Conversion from real to nominal (and vice versa) typically involves multiplying or dividing by the price level:

  • For instance, real money demand can be converted to nominal by multiplying by the price level: ext{Nominal Money Demand} = ext{Real Money Demand} imes ext{Price Level}.

• Quantity Equation of Money:

  • The foundational relationship in both markets stems from the quantity equation: M imes V = P imes Y, where:

  • M: Money

  • V: Velocity of money

  • P: Price level

  • Y: Real GDP

  • This equation can be examined for either money supply or demand, illustrating how they interrelate within the economy.

• Positive and Negative Relationships:

  • Real GDP positively correlates with real money demand: an increase in GDP leads to higher real money demand.

  • Velocity (V) is positively related to interest rates, meaning as interest rates climb, velocity increases, which inversely affects overall money demand.

  • Thus, even though $ ext{M} imes V$ expresses a direct relationship with output, it indirectly results in negative demand against interest rates due to the underlying dynamics of the equation.

• Final Equation Consideration:

  • Through careful manipulation of the quantity equation, we can derive various forms relating money supply and demand, which circle back to the real and nominal frameworks. For example, manipulating terms leads to the cancellation of price level effects when using the quantity equation.