12.3 How Money Affects Aggregate Demand Flashcards

1
Q

What is monetary equilibrium?

A

monetary equilibrium—the theory of how interest rates are determined in the short run by the interaction of money demand and money supply.

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2
Q

What is the Monetary transmission mechanism?

A

The channels by which a change in the demand for or supply of money leads to a shift of the aggregate demand curve.

Monetary transmission mechanism—the chain of events that takes us from changes in the interest rate, through to changes in desired aggregate expenditure, to changes in real GDP and the price level.

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3
Q

Graph of Monetary equilibrium

A
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4
Q

Why is the money supply curve vertical?

A

The money supply curve is vertical, indicating that it is assumed to be independent of the interest rate.

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5
Q

What causes the money supply to increase or decrease (Shift right or left) ?

A

The money supply increases ( shifts to the right) if the central bank increases reserves in the banking system or if the commercial banks decide to lend out a larger fraction of those reserves.

The money supply decreases ( shifts to the left) if the central bank decreases reserves in the banking system or if the commercial banks decide to reduce their lending.

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6
Q

Why is the money demand curve downward sloping?

A

The money demand curve is downward sloping, indicating that firms and households decide to hold more money (and fewer bonds) when the interest rate falls.

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7
Q

When does the interest rate rise and fall?

A

The interest rate rises when there is an excess demand for money and falls when there is an excess supply of money.

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8
Q

What is Monetary equilibrium?

A

Monetary equilibrium

The situation in which the quantity of money demanded equals the quantity of money supplied.

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9
Q

What does interest rate represent in the money market?

A

In the money market, the interest rate is the “price” that adjusts to bring about equilibrium.

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10
Q

What can a single household or firm do when they would like to hold more or less money?

A

When a single household or firm finds that it would like to hold more money (and fewer bonds) it can sell some bonds and add the cash proceeds to its money holdings. If the preference instead is to hold less money, the household or firm can buy bonds. Such adjustments in money and bond holdings for an individual household or firm can easily be made and will have a negligible effect on the economy.

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11
Q

Consider a disequilibrium situation in which firms and households would like to adjust their portfolios by holding more money and fewer bonds.

A
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12
Q

Consider a disequilibrium in which firms and households would like to adjust their portfolios by holding less money and more bonds.

A
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13
Q

When does Monetary equilibrium occur?

A

Monetary equilibrium occurs when the interest rate is such that the quantity of money demanded equals the quantity of money supplied.

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14
Q

What is the liquidity preference theory or interest? What is portfolio balance?

A

The theory of interest-rate determination depicted in Figure 12-2 is often called the liquidity preference theory of interest.

This name reflects the fact that when there are only two financial assets, a demand to hold money (rather than bonds) is a demand for the more liquid of the two assets—a preference for liquidity.

The theory determines how the interest rate fluctuates in the short term as people seek to achieve portfolio balance, given fixed supplies of both money and bonds.

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15
Q

What are the three stages of the monetary transmission mechanism?

A
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16
Q

What do changes in either the supply of money or the demand for money do to the equilibrium interest rate?

A

Changes in the supply of money or in the demand for money cause the equilibrium interest rate to change.

17
Q

An increase in money supply from an increase in money reserves leads to…

A
18
Q

An increase in money supply leads to…

A
19
Q

An increase in money supply with an unchanged supply of money leads to…

A
20
Q

Changes in either the demand for or the supply of money cause…

A

Changes in either the demand for or the supply of money cause changes in the short-run equilibrium interest rate.

21
Q

What does an increase in money supply do to the equilibrium intrest rate and desired investment expenditure?

A

Increases in the money supply reduce the equilibrium interest rate and increase desired investment expenditure.

22
Q

What do changes in the money supply do to the AE and AD functions?

A

Changes in the money supply cause shifts in the AE and AD functions.

23
Q

What does an increase or a decrease in the money supply do to the interest rate and desired aggregate expenditure?

A

An increase in the money supply causes a reduction in the interest rate and an increase in desired aggregate expenditure; it therefore causes a rightward shift of the AD curve.

A decrease in the money supply causes an increase in the interest rate and a decrease in desired aggregate expenditure; it therefore causes a leftward shift of the AD curve.

24
Q

Summery of moneitary transmission mechinism.

A
25
Q

How can we compare bonds from ours and simular coutries (Canada and US) and bonds from other countries?

A

Bondholders, either in Canada or abroad, are able to substitute among Canadian bonds, U.S. bonds, German bonds, and bonds from almost any country you can think of.

Bonds from different countries are generally not perfect substitutes for each other because the varying amounts of political and economic instability imply that different levels of risk are associated with different bonds. But bonds from similar countries—Canada and the United States, for example—are often viewed as very close substitutes.

26
Q

What does the ability of bondholders to substitute easily between bonds from different countries imply?

A

The ability of bondholders to substitute easily between bonds from different countries implies that monetary disturbances that cause changes in interest rates often lead to international flows of financial capital, which in turn cause changes in exchange rates and then changes in exports and imports.

27
Q

How does an increase in Canadian money supply result in an open economy?

A

An increase in the Canadian money supply reduces Canadian interest rates and leads to an outflow of financial capital. This capital outflow causes the Canadian dollar to depreciate.

28
Q

What is the overall effect of an increase in the Canadian money supply on an international level?

A

So the overall effect of the increase in the Canadian money supply is not just a fall in Canadian interest rates and an increase in investment.

Because of the international mobility of financial capital, the low Canadian interest rates also lead to a capital outflow, a depreciation of the Canadian dollar, and an increase in Canadian net exports.

This increase in net exports strengthens the positive impact on aggregate demand already coming from the increase in desired investment.

29
Q

The Open-Economy Monetary Transmission Mechanism

A
30
Q

In an open economy with capital mobility, an increase in the money supply causes…

A

In an open economy with capital mobility, an increase in the money supply causes an increase in aggregate demand for two reasons.

First, the reduction in interest rates causes an increase in investment.

Second, the lower interest rate causes a capital outflow, a currency depreciation, and a rise in net exports.

31
Q

What were the two reasons we have previously learned as to thy the AD curve is negativly sloped?

A

a change in the price level causes a change in wealth and also causes a substitution between domestic and foreign goods.

32
Q

What is the theird reason for why the AD curve is negativly sloped?

A

A rise in the price level raises the money value of transactions and thus leads to an increase in the demand for money.

For a given supply of money (a vertical curve), the increase in money demand means that the curve shifts to the right, raising the equilibrium interest rate.

The higher interest rate then leads to a reduction in desired investment expenditure (and, in an open economy, to a reduction of net exports).

33
Q

To summarize, in our more complete macro model, the AD curve is downward sloping for three reasons.

A

As the domestic price level changes:

Domestic wealth changes

Substitution of expenditure occurs between domestic and foreign products

The interest rate changes, which leads to changes in investment and net exports

34
Q

What direction do the three effects of why AD curve is negativly sloped move in with a rise and fall in price level?

A

As the price level falls, all three effects work in the same direction, increasing desired aggregate expenditure.

As the price level rises, the three effects work in the same direction, decreasing desired aggregate expenditure.