5b Flashcards
What is the liquidity preference framework?
it determines the equilibrium interest rate based on the supply and demand for money.
What are the two assets in the liquidity preference framework?
Money (liquid, no interest) and Bonds (less liquid, earn interest).
What happens if the money market is in equilibrium?
The bond market must also be in equilibrium.
What is the equation for total wealth in the economy?
W=Bd+Md=Bs+Ms, where wealth is held as money or bonds.
What happens when there is excess supply in one market?
There is excess demand in the other market:
Bs−Bd=Md−Ms
How does interest rates relate to the demand for money?
It is negatively sloped; as interest rates rise, money demand decreases.
What are the key characteristics of money and bonds?
Money: Liquid but earns no interest
Bonds: Less liquid but earns interest
What determines the supply of money?
The central bank controls money supply through monetary policy.
What happens to interest rates with excess supply of money?
Interest rates fall.
What happens to interest rates with excess demand for money?
Interest rates rise.
How does income affect money demand?
Higher income means agents hold more money which increases money demand for transactions and as a store of value. demand increases at each interest rate so demand curve shifts to the right
How does the price level affect money demand?
Higher prices increase money demand to maintain purchasing power. thus demand for money increases art each interest rate so demand curve shifts to the right
What happens when the central bank increases the money supply?
The money supply curve shifts right, reducing interest rates. (vice versa for a reduction in money supply)
What is the Liquidity Effect?
An increase in money supply leads to a decrease in interest rates.
What is the Income Effect?
Higher money supply increases income, so wealth rises which raises bond supply and demand, leading to higher interest rates.
What is the Price-Level Effect?
Higher money supply increases price levels, raising money demand and interest rates.
What is the Expected-Inflation Effect?
Higher money supply increases inflation and expected inflation, raising interest rates.
Which effect dominates in the short run?
The liquidity effect dominates in the short run (interest rates fall).
Which effects dominate in the long run?
The income, price-level, and expected-inflation effects dominate in the long run (interest rates rise)
