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MGT411 - Money & Banking - Lecture Handout 39

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  • Money is just one of many financial instruments that we can hold in our investment portfolios.
  • Expectations that interest rates will change in the future are related to the expected return on a bond and also affect the demand for money.
  • When interest rates are expected to rise, money demand goes up as people switch from holding bonds into holding money.
  • The demand for money will also be affected by changes in the riskiness of other assets; as their risk increases so does the demand for money.
  • Money demand will increase if other assets become less liquid.
Determinants of Money Demand: Factors that cause individuals to hold more money
Transactions Demand for Money
National Income
Interest rates
Availability of alternative means
of payment
The higher nominal income, the higher the demand for money
The lower interest rates, the higher the demand for money
The less available alternatives means of payment, the higher the demand
for money
Portfolio Demand for Money
Return relative to alternatives
Expected future interest rates
Risk relative to alternatives
Liquidity relative
As wealth rises, the demand for money goes up
As the return on alternatives falls, the demand for money goes up
As expected future interest rates rise, the demand for money goes up
As the riskiness of alternatives rises, the demand for money goes up
As the liquidity of alternatives falls, the demand for money goes up

Targeting Money Growth in a Low-Inflation Environment

  • In the long run, inflation is tied to money growth.
  • In a high-inflation environment moderate variations in the growth of velocity are a mere annoyance.
  • The only solution to inflation in a high inflation environment is to reduce money growth.
  • In a low-inflation environment, the ability to use money growth as a policy guide depends on the stability of the velocity of money.
  • Two criteria for the use of money growth as a direct monetary policy target:
  • A stable link between the monetary base and the quantity of money
  • A predictable relationship between the quantity of money and inflation
  • These allow policymakers to Predict the impact of changes in the central bank’s balance sheet on the quantity of money
  • Translate changes in money growth into changes in inflation.

Output and Inflation in the Long Run

  • Potential Output
  • Potential output is what the economy is capable of producing when its resources are used at normal rates.
  • Potential output is not a fixed level, because the amount of labor and capital in an economy can grow, and improved technology can increase the efficiency of the production process
  • Unexpected events can push current output away from potential output, creating an output gap
  • In the long run, current output equals potential output.
  • Long-Run Inflation
  • In the long run, since current output equals potential output, real growth must equal growth in potential output.
  • Ignoring changes in velocity, in the long run, inflation equals money growth minus growth in potential output.
  • Though central banks focus on controlling short term nominal interest rates, they keep an eye on money growth
  • When they try to adjust level of reserves in banking system to maintain interest rate, it affects money growth. Which in turn determines inflation

Money Growth, Inflation, and Aggregate Demand

  • Aggregate demand tells us how spending (demand) by households, firms, the government, and foreigners changes as inflation goes up and down.
  • The level of aggregate demand is tied to monetary policy through the equation of exchange (MV=PY) because the amount of money in the economy limits the ability to make payments.
  • Rearranging the equation of exchange

Rearranging the equation of exchange

  • Where Yad = aggregate demand,
  • M = the quantity of money,
  • V = the velocity of money, and
  • P = the price level.
  • From this expression it is clear that an increase in the price level reduces the purchasing power of money, which means less purchases are made, pushing down aggregate demand

pushing down aggregate demand

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