Lent - Lecture 5 - The Money Market Flashcards
What equation is demand for real money balances assumed to satisfy? Describe i and Y here, and how they affect demand for real money balances
- M/P = L(i, Y)
- depends positively on Y and negatively on i
- i: opportunity cost of holding money instead of bonds (the ‘price’ of holding)
- Y: transaction demand for money
From M/P = L(i, Y), and assuming L is homogenous of degree 1 in Y, show that V ≡ 1/l(i)
- M/P = L(i, Y)
- L is homogenous of degree 1 in Y:
- L(i, Y) = Y ⋅ L(i, 1) ≡ Y ⋅ l(i)
- M/P = Y⋅l(i)
- M ⋅ 1/l(i) = PY
- the quantity equation, with V ≡ 1/l(i)
For the money market to make sense, what side of the economy do we need to model?
model the supply side
Derive a money market supply curve from the Classical approach (hint: i = …)
- assume exogenous M, growing at a fixed rate gM, but endogenous P
- two key steps:
1) r in Fisher equation is determined by the goods market
2) πe in Fisher equation is determined by money growth - i = r̅ + πe
- i = r̅ + gM - gY
In the Classical money market, explain the roles/determination of i and P?
- a unique i, determined by r̅, gM and gY
- P adjusts to ensure equilibrium with money demand
What are the two key changes for the Keynesian approach to the money market (supply side), compared to the Classical approach?
- for the Keynesian approach:
- P is no longer endogenous to money market alone (P is never just used to clear the money in Keynesian models)
- πe is exogenous ⇒ changes to i affect r
Derive a money market supply curve from the Keynesian approach (following MP rule)?
- CB chooses desired R:
- R = r̅ + mπ(π - πt) + mY(Y - Y̅)
- Given πe, this implies setting i to:
- i = πe + r̅ + mπ(π - πt) + mY(Y - Y̅)
- M is supplied perfectly elastically to implement this, so we get a perfectly elastic supply curve
In the Keynesian money market (following MP rule), explain the roles/determination of i, M and P?
- i is chosen by the CB (e.g. via the Taylor rule)
- M adjusts to ensure equilibrium
- P is exogenous / determined by other factors
Is it the Keynesian or Classical money market supply curve which is like a usual perfectly elastic supply curve?
- the Keynesian model
- as it is M, not P, that adjusts for equilibrium
What is the alternative way to approach the supply side of the money market in a Keynesian model (not setting i via the MP rule)?
- instead of setting i via the MP rule, we could assume the CB fixes M:
- M = M̅
- takes us to the other extreme: perfectly inelastic M/P
In the Keynesian money market (fixed M approach), explain the roles/determination of i and M?
- CB chooses M ⇒ M̅/P fixed
- i adjusts to clear market
Derive the LM curve
- higher Y implies higher demand for real money due to the transactions motive
- a desire to sell bonds drives down their price
- this increases i… until the opportunity cost of holding M/P is high enough for equilibrium
- this gives us a positive relationship between i and Y
- known as the LM curve
The LM curve charts the (i, Y) combinations consistent with money market equilibrium, given fixed M. What will cause it to shift?
- it will be shifted by anything that affects this equilibrium for a given Y:
- changes in M
- changes in P
- exogenous changes in liquidity demand
The LM curve will be flatter the less i changes for a given change in Y. What does this depend on?
- the income elasticity of money demand
- how much does L(i, Y) change as Y increases?
- the interest elasticity of money demand
- how much does i have to adjust to restore money market equilibrium?
