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Chapter 12
Money,
Banking,
Prices, and
Monetary
Policy
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The Inflation Rate (1) and The Fisher Relation (2)
(1)
P' P
i
P
(2)
1 R
1 r 
1 i
(2 approx)
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r  R i
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Nominal Money Demand
• Substitute using the approximate Fisher relation.
M d  PL(Y , r  i)
• For some of our experiments, suppose inflation rate is
zero (harmless, it’s short run).
M d  PL(Y , r )
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Figure 12.5
The Nominal Money Demand Curve in the
Monetary Intertemporal Model
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Figure 12.6
The Effect of an Increase in Current Real Income on
the Nominal Money Demand Curve
per dato P
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an increase in r does
the opposite (more
convenient investing
in bonds)
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Figure 12.7
The Current Money Market in the Monetary
Intertemporal Model (with inflation)
• ↑ Ms => P ↑ (old story)
• ↑ Md (e.g. ↑ liquidity
preference) => r ↑ => I ↓
=> Y ↓ => P ↓
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Labor Demand and Labor Supply
Real
wage =
w = W/P
Nd=labor demand (employers)
Ns=labor supply(employees,
workers): if r (from today
onwards) ↑ => better to work
harder today and save for
tomorrow
(intertemporal model)
Ns also positively depends
upon W (nominal)
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Figure 12.9
A Level Increase in the Money Supply in the
Current Period
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Figure 12.10
The Effects of a Level Increase in M
The Neutrality of Money (hp perfect information)
In a monetary intertemporal
model, a level increase in the
money supply increases the
price level and the nominal
wage in proportion to the
money supply increase, but has
no effect on any real
macroeconomic variable.
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The Short-Run Nonneutrality of Money:
Friedman-Lucas Money Surprise Model
(hp imperfect information)
• Different aggregate shocks hit the economy – money
supply shocks and productivity shocks – and
consumers cannot observe these shocks directly.
• Imperfect information: consumers know the market
nominal wage, but they do not observe all prices
simultaneously, so they do not know their real wage.
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Figure 12.14
The Effects of an Unanticipated Increase in the
Money Supply in the Money Surprise Model
• Money supply increases:
workers see an increase in
their nominal wage, and
think that their real wage
has increased.
• Workers supply more
labor, labor becomes
cheaper and output
increases.
• Nonneutrality of money,
but only because people are
fooled into working harder.
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Shifts in Money Demand: now the CB is
uninformed!
• These shifts are important for how monetary policy
should be conducted.
• Shifts in the demand for money that occur within a day,
week or month (the very short run) are a critical for the
central bank.
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A Shift in the Demand for Money
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Instability in Money Demand
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Shocks that the central bank is concerned with
• money demand, output demand, output supply
• Key problem for the central bank: it cannot observe
the shocks directly, and does not have timely
information on all economic variables.
• Two alternative policy rules which central banks have
adopted: money supply targeting, interest rate
targeting.
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Figure 12.15:
A Surprise Increase in Money Demand When
There Is MONETARY TARGETING by the Central
Bank (constant M, or CONSTANT GROWTH RATE of M)
2) P↓, W (nom.)↓
workers reduce
labor supply
N↓, w (real)↑
Interest rate targeting
would be less (output)
destabilizing
3) less labor (more
expensive) => Y supply ↓
+ money dem. ↑ => r ↑
Typo in the book:
switch Y1 and Y2
1) Money
demand
increases (e.g.
preference for
liquidity): P↓
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Figure 12.16
A Total Factor Productivity Increase When There Is
INTEREST RATE TARGETING by the Central
Bank
1) TFP↑ => employers ↑ labor demand
N ↑, w (real)↑
4) P↓ => W↓=> employees ↓ labor supply
Notice: W↓= w ↑*P↓↓
2) pressure for Y supply↑ and
decrease in prices => pressure for r↓
3) In order to prevent r↓ the CB must
↓Ms => P↓
This destabilizes prices!
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Optimal Central Banking
• What tends to work well in practice is for the central
bank to target a short-term nominal interest rate in the
very short run, and to consider changing this target
every few weeks.
• There is much volatility in money demand in the very
short run – interest rate targeting accommodates this.
• Productivity shocks are slower moving – the interest rate
target can change in response.
• Mostly used: Taylor rule
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The Zero Lower Bound and Quantitative Easing
• Zero lower bound: The nominal interest rate cannot go
below zero
• What happens when r = 0 ? At the zero lower bound
there is a liquidity trap. Increasing the money supply
through conventional means does not do anything –
even prices do not change.
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Figure 12.18
A Typical Yield Curve
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Quantitative Easing
• Under conventional accommodative monetary policy, the
central bank swaps money for short-term government
securities, drives down short-term interest rates and
stimulates short-run investment.
• But in a liquidity trap, this does not work.
• However, long-term nominal interest rates can be positive
when short-term rates are zero.
• What if the central bank purchases long-term government
securities? Long-term interest rates should go down =>
long term investment should increase and Y can also
increase
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