Chapter 19: Demand For Money and Quantity Theory Flashcards
monetary theory
the study of the effects of money and monetary policy on the economy
Quantity Theory of money
- explains how the nominal value of aggregate income is determined
- how much money is held for a given amount of aggregate income
- interest has no effect on Md
- P * Y = M * Constant V
P x Y
- total spending
- aggregate nominal income
velocity of money
average number of times per year that a dollar is spent
- V = P * Y/M
equation of exchange
relates nominal income to the quantity of money and velocity
- V * M = P* Y
What determines velocity?
institutions within an economy that affect the ways in which individuals conduct transactions
Classical Theory (Fisher)
- V is fixed
- institutional and technological features of the economy would affect velocity slowly over time
- demand for money is a function of income
- interest rates have no effect on demand for money
demand for money
the quantity of money that people want to hold onto
demand for money equation
Md = k * PY
relationship between quantity theory and price level
changes in the quantity of money lead to proportional changes in price level
relationship between quantity theory and inflation
ΔP/P = Δm/m + Δv/v - ΔY/Y
quantity theory of money in short run
- not a good theory in SR
- “inflation is always everywhere a monetary phenomenon” is only true in LR
ways the government can pay for spending
- raise revenue (tax)
- borrow (debt)
- create money
government budget constraint
DEF = G(excess of gov spending) - T(tax) = change MB + change B (bonds)
deficit financed by increased bond holdings by public
no change in MB and MS
deficit not financed by bonds held by public
increase in MB and MS
monetizing the debt
when government debt issued to finance government spending has been removed from the hands of the public and has been replaced by high powered money
printing money
creation of high powered money
what happens with persistent money creation
inflation
hyperinflation
periods of extremely high inflation of more than 50% per month
liquidity preference theory (Keynesian Theory)
three motives behinds the demand for money
1. transactions motive
2. precautionary motive
3. speculative motive
transaction motive
individuals are assumed to hold money because it is a medium of exchange that can be used for everyday transactions
payment technology
new methods of payment which affect the demand for money
precautionary motive
people hold money as a cushion against unexpected oppotunities
speculative motive
people hold money as a store of wealth
- As i increases, opportunity cost of money increases and the quantity of money falls
real money balance
quantity of money in real terms
liquidity preference function
Md/P = L(i,Y)
V = PY/M = Y/L(i,Y)
- demand for money has a negative relationship with nominal interest rate and positive relationship with real income
theory portfolio choice and Liquidity preference
as i rises, expected return on money does not change, return on bonds rises
dominated assets
currency and checkable deposits
- investors can hold other assets that pay higher returns and are safe
inflation hedges
real returns are less affected than that of money when inflation rises
liquidity trap
conventional monetary policy has no direct effect on aggregate spending b/c change in MS has no effect on i
stability of Md
if Md is unstable, velocity is unpredictable, and the quantity of money is not tightly linked to aggregate spending
- the steady growth of MS is an ineffective way to conduct MP
factors that shift Md curve
- interest rates -
- income +
- payment technology -
- wealth +
- riskiness of other assets +
- inflation -
- liquidity of other assets -
velocity and interest rates
when i increases, v increases
demand for real money and interest rates
Md increases, i decreases
demand for real money and real income
Md increases, real income increases
why did Keynes believe that interest rates affect the demand for money?
Interest rates affect the demand for other assets that may be preferred over money
