Download Lecture 17 - Nottingham

L11200 Introduction to Macroeconomics 2009/10
Lecture 17:
Money and the Price Level II
Reading: Barro Ch.10
4 March 2010
Introduction
• Last time:
– Constructed a realistic model of money demand
– Setup the equilibrium between demand and
supply
– Increases in money supply change nominal
variables, but leave real variables unchanged
• Today
– Consider changes in money demand
– Explain empirical pattern of prices and GDP
Money Supply Shifts
• Shifts in money supply changed the price level
by shifting supply schedule out/in
– Raised the price level
– But also raised all nominal variables (prices, wage,
rental cost) so real variables unchanged
– Now consider factors which shift money demand
Money Demand: Innovation
• Money demand determined by balance of
costs
– Cost of holding money: interest foregone
– Cost of not holding money: having to more
regularly transact bonds to access cash
– So financial innovation (transactions technology)
lowers the cost of holding money
– E.g. ATMs, debit cards, electronic transfer all
reduce the cost of not holding money
Money Demand: Innovation
• If innovation lowers cost of not holding
money, households choose to hold less money
– Off-load their unnecessary money by purchases of
goods and bonds
– Increases nominal demand for goods and bonds,
so increases nominal prices
– One-off increase in the price level
– All real variables unchanged
Money Demand: i and Y
• Money demand also changes when interest
rates and overall output changes
• Impact on money demand of positive shock to
A, would be:
– Higher i decreases money demand as interest
foregone increases
– Higher Y increases money demand as household
need more cash to service transactions
Which effect is bigger?
• Overall effect on demand depends on relative
strength of the two effects
– Sensitivity of money demand function L(i,Y) to
changes in i and Y
– Empirical evidence suggests that the effect of i
changes on demand is less than effect of Y
changes
– So expect that demand increases as Y increases,
so prices are countercyclical
Price-Level Targeting
• In principle, introducing money causes no
problems in the economy because individuals
care about real values
– In practice, policymakers worry than inflation is
costly because it causes price uncertainty
– Households find it difficult to plan for the future
(write nominal contracts) when prices vary
– So policymakers try to stabilise prices
Endogenous Money
• How can they do this: money supply
– Whenever money demand rises / falls,
government can respond by changing money
supply so that prices remain the same
– Call this process ‘endogenous money creation’
– Reaction to money demand, hence money supply
is endogenous in the model
Targeting the Price-Level
• Equilibrium in the money market
M  P  L(Y , i )
• Can offset effect of increases in Y,i on P by
altering M. Target level of P is P-bar
M  P  L(Y , i )
How to Price-Target
• Long-term technological progress implies Y is
growing over time
– If Y is growing over time, demand for money is
also growing, so price level falling over time
– To maintain stable prices, need to increase M to
offset the effect
M  P  L(Y , i)
How to Price-Target
• Short-term fluctuations implies Y fluctuations
need to be matched by M fluctuations
– Over business-cycle, Y rises and falls
– Need to stabilise P by altering money supply in
ling with changes in Y
– Y rises: expand money supply
– Y falls: reduce money supply
– Known as ‘cyclical money management’
Summary
• From money demand function, expect prices
to be counter-cyclical
– Evidence suggests this is the case
– In recessions, households hold more cash and so
price level falls
– Price-targeting can reduce price uncertainty
• Next time: consider inflation
– So far considered static scenario, next consider
dynamics and implications for inflation