Topic 8: Money Supply and Demand

Question 1

What is the trade off of money

Answer 1

Trade off between money usefulness and poor store of value

Question 2

Opp cost of holding unit of money

Answer 2

i - im (forgone interest)

Question 3

Real money balances calculated

Answer 3

M/P

Question 4

marginal benefit of extra unit of real balances

Answer 4

b (M/P)

b is a function of marginal benefit

b(M/P) is generally positive but diminishing towards 0 as M/P rises

Question 5

What is the optimum of the trade-off of underlying money demand

Answer 5

Marginal Benefit = Marginal cost

b(M/P) = i - im

focus on im = 0 (cash) where b(M/P) = i gives money demand

Question 6

Draw the money demand curve

Answer 6

Demand curve from i = b(M/P)

Higher real GDP Y increases transactions –> need for money rises –> b(M/P) shifts up

M/P = L (Y,i)

L (Y, i) increasing in real GDP Y; decreasing in nominal rate i (opp. cost of holding money)

Question 7

Draw the interest rate lower bound on nominal interest rates

Answer 7

Question 8

Assuming a security/storage cost of s on each unit of cash

Draw the new demand for cash and lower bound

Answer 8

Md/P shifted downwards by size of prop security cost s

but still lower bound and s likely < 1%

Increases scope of MP use

Question 9

What is relationship between GDP and inflation in the long run

Answer 9

No link as real GDP always at market clearing Y * irrespective of inflation π

Flexible-price Phillips curve verticala

Question 10

What is the theory of inflation and quantity of money

Answer 10

Inflation linked to quantity of money

Friedman beleived was always a monetary phenomenan

Question 11

Implications of money demand = money supply

Answer 11

• CB chooses the supply of money M^s
• Price level P assumed fully flexible to reach M(d) = M(s)

Question 12

Determine the money growth rate

Answer 12

u = (M’ - M)/M

Question 13

Determ,ine the equilbrium price level with flexible wages and prices

Answer 13

Flexible prices –> demand = supply in goods and labour –> Y * and r *

Md = PL ( Y * , i)

Fischer equation implies -> Md = PL( Y * , R * + π’e)

implies
–> P = M/L ( Y * , r * + π’e)

Question 14

Draw the money-market equilibrium

Answer 14

P inversely related ot real value off money in terms of goods

Question 15

All else equal, what does money supply growth rate (u) determine

Answer 15

u determines inflation. hence:

π’e = u

i = r * + u

Question 16

Answer 16

Question 17

Question 18

social benefit of money

Answer 18

money’s usefulness in facilitating transaction

Question 19

is foregone interesst a cost of holding money

Answer 19

it is a private but not social cost (as fiscal benefit gainend by gov)

Question 20

What is the private and sociallly efficient holdings off money

Answer 20

Social:

where MSB=0 so b(M/P) = 0

Private:

b(M/P) = i (if im = 0)

so high inflation reduces social gains from money

Question 21

what is friedman rule

Answer 21

Money utiliised efficiently only if i = 0

‘Friedman rule’

Question 22

What is seigniorage

Answer 22

Fiscal gains from issuing money:

• No obligation to repay or redeem fiat money
• Money may pay no or less interest than bonds

these gains are implicit tax on holders of money

Question 23

What fiscal advantage from printing money

Answer 23

• Money used to directly finance gov expenditure; worth uM/P
• Also saving interest payments if financed through bonds

More typical case is CB buying asssets w new money

Question 24

Measure the fiscal advantage from steady money supply growth or buying nominal bonds

Answer 24

Bonds:

CB holds bonds of M value earning interest iM each period

Earn profits iM/P recieved in each time period

Steady Money Supply Growth:

• Seigniorage reduces gov. borrowing cossts by issuing money isntead of bonds
• Hence iM/P still accuarately measures gains

Question 25

Draw the graph of seigniorage revenues

Answer 25

Higher i --> Money becomes worse store of value --> money demand is lower forms a laffer curve

Question 26

What could impact CB profits from the asssumption of no interesst on money, CB buys only safe, short term bonds as assets

Answer 26

1. Interest paid on reserves reducing CB profits to (i - ir)M/P - seigniorage eliminated by floor system (i = ir) 2. Other CB standing facilities; higher i(b) can raise CB profits 3. CB may buy long-term bonds or other risky assets; could make losses or profits

Question 27

What is the inflation tax

Answer 27

Fiscal advantage from suprise inflation - real debt burden declining from suprise inflation only works with suprise inflation as real return prottected from expected inflation

Question 28

What is the liquidity trap

Answer 28

At i=0, zero marginal benefit of holding money: b(M/P) = 0 --> indifferent about higher M -- shift does not change IR Extra money held and nothing else changes

Question 29

What is the difference between temporary and permanent money supply changes

Answer 29

Temporary: doesn't change expectations of P'e Permanent: current P reliiant on future M'e which is affected by permanent shift as P = P'e / (1-r)

Question 30

Implication of temporary and permanent money supply changes for QE

Answer 30

At IR lower bound, temp. increase in money supply has no impact on prices In liquidity trap, only expectations of future money supply matter QE Design implications: - Commit to a monetary expansion even once i > 0 - Helicopter drop if im > 0, ma be that i = im permanently so may not lend even if IR rise

Question 31

What is demand for money based off

Answer 31

trade off between usefulnes as a medium of exchange and its generally poor store of value (low or -ve inflation best)

Question 32

What is usefulness of money based off

Answer 32

Depends on its real value; greater supply reduces real value of each unit

Question 33

What happens to money and short-term risk free bonds at interest rate lower bound

Answer 33

Money and short-term risk-free bonds become perfect substitutes Thus QE can fail to have any effects unless the CB buys risky assets