week 6 Flashcards
quantity theory of money
MV=PY
stability of Velocity
stability of Y income
interest rate transmission mechanism
1- money supply changes- interest rate link
2- interest rate- investment link
3- aggregate demand changes as a result so does multiplier effect
monetary transmission mechanisms (IR)
money supply increase
interest rate decrease
investment increase
saving decrease
aggregate demand increase
GDP (Y) increase
price (P) increase
effect of rise in money supply
increase money supply= lower interest = higher investment willing
withdrawals = injections
= aggregate demand on interest rate transmission mechanism
investment increase
means injections increase in equation. causes equilibrium to increase
limitations of interest rate transmission (stage 1 money- interest rate link)
elastic demand for money
unstable demand for money
liquidity trap
a situation where monetary policy becomes ineffective because interest rates are near zero, and people prefer to hold cash rather than invest or spend, even with low borrowing costs
effect of fluctuating demand
with a fixed money supply, fluctuations in demand can lead to fluctuations in interest rates. increase interest rate = more demand
limitations of interest rate transmission (stage 2 interest rate - investment link)
inelastic investment demand
unstable investment demand
different views on demand for investment
inelastic- changes in investment small resulting in small change in AD
effects of unstable investment demand curve
fall in interest rates (increased confidence) small increase in investment levels Q0-Q1. l2 means Q0-Q2 more effective
effects of unstable investment demand curve
fall in interest rates (decrease confidence) causes small increase in investment Q0-Q1 but money supply fall causing Q0-Q3 investment to decrease
consider balance sheets
pre cautionary effects
cash flow effects
cash flow effects
as household, if you have short term debts, and interest rates are lowered, you pay less interest meaning consumption may rise
precautionary effects (precautionary saving)
decrease interest rates as as signal of a recession
people start saving
increase hurdle rate of interest
investment may decrease
summary interest rates falling
savings go down and investment goes up
hurdle rate of interest
minimum return on an investment that is needed to make the investment. if anticipate recession, require higher return on any potential investment in order to make the investment
exchange rate transmission mechanism stages
money supply- interest rate link
interest rate - exchange rate link
exchange rate - import and export link
monetary transmission mechanism
demand for foreign assets increase as money supply increases. exchange rate falls (pound depreciates) as less demand for pound. foreign goods more expensive so imports fall and export increase. aggregate demand increases
exchange rates affecting imports and exports
pound weaker, exports higher
interest rates effecting exchange
interest rates determined in money market.
interest rates affect demand and supply in foreign exchange market
exchange rates affect equilibrium
exports are an injection. imports are a withdrawal. exports increase = injections increase. withdrawals go down as fewer imports
effect of an increase in money supply
demand for foreign assets increase, supply of pound increase. demand for pound falls. more exports, less imports = trade surplus
summary exchange rate transmission mechanism
lower interest rates = demand foreign currency
theory of portfolio balance
mechanism stressed by monetarists. Keynesian critique
money supply increase
supply > demand
=surplus liquidity
=used to buy goods/services which will eventually increase aggregate demand
monetary growth in UK
excess nominal money balances as an indicator of short term activity and price movement. growth rate of money holdings of sub-sectors
short run variability of velocity
depends on whether money supply is directly controlled
e.g. the use of quantitative easing in response to the aftermath of the financial crisis and the Covid-19 pandemic
crowding out
public sector goes up, private investment sector goes down
extent of crowding out
responsiveness of demand for money to an interest rate change
responsiveness of investment to an interest rate change
different views on demand for money (elasticity)
Keynesian believe liquidity preference curve is elastic
new classical/ monetarists believe curve is inelastic
different views on demand for money (interest rates)
Keynesian believe change in demand for money has small effect on interest rate
new classical/ monetarists believe change in demand for money had large effect on interest rate
different views on demand for money (investment curve)
Keynesian believe interest investment curve relatively inelastic
new classical/ monetarists believe interest investment curve elastic
money supply exogenous or endogenous
Keynesians- total endogenous (affected by aggregate demand)
monetarists- total exogenous (crowding out takes place)
need to reduce endogenous element if government
contemporary analysis applies the IS/MP model
equilibrium in goods market
interest rates are key tool of monetary policy In many countries
inflation rate target
elasticity of IS curve
-more responsive I and S- larger effects on national income = elastic IS
-size of multiplier (1/mpw)
-Keynesians; inelastic IS - interest rates don’t affect goods market much
-monetarists; elastic IS - interest rates significantly affect saving & investment
the IS curve
real interest rate, national income and equilibrium in goods market
every point on curve withdrawals = injections
MP curve
national income and real interest rate chosen by monetary authorities
deriving mp curve
-inflation targeting by central banks
-price expectations inertia
deriving MP curve
rise in national income leads to higher rate of inflation and hence central bank raising interest rates to bring inflation back towards the target
mp curve shifts
change in national income Y; shift to right
inflationary shock; MP shifts upward
change in target rate of inflation; MP shifts downwards
evidence of credit cycles
financial accelerator
- interest rate differentials
-availability of credit
-interaction of multiplier and financial accelerator
-financial accelerator and the IS/MP framework
financial instability hypothesis
-stages of credit accumulation (financial tranquility, fragility and bust)
-irrational exuberance (euphoria - confidence - increase exp returns on assets)
-minsky moment (economic shock after irrational exuberance)
-balance sheet recession
IS/LM model analysis
no inflation target
central bankdirectly influence money supply
the IS curve
movement along versus shifts of IS curve
the LM curve
deriving the LM curve
money market equilibrium
