Week 8

Question 1

What is Liquidity preference framework?

Answer 1

• The liquidity preference framework which analyses the market for money, is equivalent to a framework analysing supply and demand in the bond market
• In practice, the approaches differ, because the liquidity
  preference framework implicitly ignores any effects on interest
  rates that arise from changes in the expected returns on real
  assets (i.e. automobiles and houses)
• The bond supply and demand framework is easier to analyse
  the effects of changes in expected inflation on interest rates
• The liquidity preference framework is simpler to analyse the effects of changes in income, price level, and the supply of money on interest rates.

Question 2

What is the equation for total wealth in the economy?

Answer 2

Bs + Ms = Bd + Md

Question 3

How do you rearrange the total wealth equation for market equilibrium?

Answer 3

• Total wealth in the economy:
  Bs + Ms = Bd + Md
• Rearrange the equation above:
  Bs − Bd = Md − Ms
• If market is in equilibrium,
  Bs − Bd = 0 and Md − Ms = 0

Question 4

What is opportunity cost of holding money?

Answer 4

• If interest rate increases, the amount of interest (expected
  return) sacrificed by not holding the alternative asset—a bond
  rises
• That is: the opportunity cost of holding money increases
• So money is less desirable and the quantity of money demanded must fall

Question 5

How does income effect shift money demand?

Answer 5

Income Effect:
- As an economy expands and income rises, wealth increases
and people will want to
1) hold more money as a store of value
2) carry out more transactions using money
- a higher level of income causes the demand for money at each
interest rate to increase and the demand curve to shift to the
right

Question 6

How does price-level effect shift money demand?

Answer 6

Price-Level Effect:
- People care about the amount of money they hold in real
terms
- When price level increases, the purchasing power of money
decreases
- a rise in the price level causes the demand for money at each
interest rate to increase and the demand curve to shift to the
right

Question 7

What are shifts in the money supply?

Answer 7

-Shifts in the supply of money:
- Assume that the supply of money is controlled by the central
bank
- An increase in the money supply engineered by the central bank will shift the supply curve for money to the right

Question 8

What can increase supply of money cause other factors to change?

Answer 8

• Income level: increase in money supply has an expansionary influence on the economy =⇒ raise national income and wealth
• Price level: increase in money supply causes the overall price
  level in the economy to rise
• Expected inflation: increase in money supply leads to a higher
  price level in the future, thus a higher inflation rate; and a
  higher inflation rate increases people’s prediction on expected
  inflation

Question 9

Price-level effect and expected-inflation effect: What are
the differences?

Answer 9

-Price-Level Effect focuses on the current impact of actual inflation (or deflation) on purchasing power and economic activity.
-Expected-Inflation Effect focuses on how people’s expectations about future inflation influence their economic decisions, even before inflation actually happens.

Question 10

How does a higher rate of growth of the money supply lower interest rates?

Answer 10

1. Income effect finds interest rates rising because increasing the money supply has an expansionary influence on the economy(the demand curve shifts to the right).

2.Price-Level effect predicts an increase in the money supply
leads to a rise in interest rates in response to the rise in the
price level (the demand curve shifts to the right).

3.Expected-Inflation effect shows an increase in interest rates because an increase in the money supply may lead people to expect a higher price level in the future (the demand curve
shifts to the right)

Question 11

How long does a higher rate of growth of the money supply lower interest rates?

Answer 11

• The liquidity effect from the greater money growth takes
  effect immediately as the rising money supply leads to an
  immediate decline in the equilibrium interest rate.
• The income and price-level effects take longer to work,
  because time is needed for the increasing money supply to
  raise the price level and income
• The expected-inflation effect can be slow or fast, depending
  on whether people adjust their expectations of inflation slowly
  or quickly