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Lecture notes Prepared by Anton Ljutic CHAPTER EIGHT The Money Market © 2004 McGraw–Hill Ryerson Limited This Chapter Will Enable You to: • Recognize that demand for money is not the same as desire for income • Distinguish two types of money demand • Explain the downward sloping money demand curve • Explain and illustrate graphically how the money supply and demand affect the equilibrium interest rate • Describe two views of how the money market affects the level of real GDP and inflation © 2004 McGraw–Hill Ryerson Limited The Supply of Money Rate of interest • The supply of money is determined by the Bank of Canada, which, can and and does change the money supply as it sees fit MS Figure 8.1 © 2004 McGraw–Hill Ryerson Limited Quantity of money The Demand for Money • Transactions demand for money – The desire of people to hold money as a medium of exchange, that is, to effect transactions – The major determinants are the level of real income and the level of prices • Asset demand for money – The desire by people to use money as a store of wealth, that is, to hold money as an asset – The major determinant is the rate of interest © 2004 McGraw–Hill Ryerson Limited Transactions Demand MDT r The transactions demand for money is unrelated to the rate of interest r1 r2 Figure 8.2A Q © 2004 McGraw–Hill Ryerson Limited Q of M Asset Demand r There is an inverse relationship between the asset demand for money and the interest rate r1 r2 MDA Figure 8.2B Q1 Q2 Q of M © 2004 McGraw–Hill Ryerson Limited Total Money Demand r MDT It is the addition of the transactions and asset demand MDA © 2004 McGraw–Hill Ryerson Limited MD= MDT+ MDA Q of M The Demand for Money is Determined by: • The level of transactions (real GDP) • The average value of transactions ( the price level) • The rate of interest – The annual rate at which payment is made for the use of money (borrowed funds); a percentage of the borrowed amount © 2004 McGraw–Hill Ryerson Limited Equilibrium in the Money Market Surplus r3 •At equilibrium interest rate, r1, there is no surplus or shortage of money. •At any other rate there is either a shortage (e.g., r2) or a surplus (e.g., r3). MS r1 r2 Shortage Q1 MD Q of M © 2004 McGraw–Hill Ryerson Limited Figure 8.3 A Shift in the Supply of Money MS1 Surplus r1 r2 Q1 Figure 8.4 •An increase in the supply of money from MS1 to MS2 will initially cause a surplus of money at the prevailing interest rate r1. •People will want to MD dispose of the surplus by buying bonds. This will cause bond prices to rise and interest rate Q of M to fall to r2. MS2 Q2 © 2004 McGraw–Hill Ryerson Limited An Increase in the Demand for Money MS1 r2 r1 Shortage MD2 MD1 Q of M © 2004 McGraw–Hill Ryerson Limited •Total demand for money will change if nominal GDP changes. •A higher price level or a higher GDP will shift the demand for money curve to the right. •This will initially cause a shortage of money, causing people to sell some of their bonds and causing bond prices to fall and interest rates to rise from r1 to r2 Money Market’s Effect on the Economy • The money market and the product market are intrinsically linked • The transmission process illustrates that the interest rate is the link between the two markets – Transmission process • The Keynesian view of how changes in money affect (transmit to) the real variables in the economy • Investment demand – Investment is the most affected by changes in the interest rate and the relationship is inverse © 2004 McGraw–Hill Ryerson Limited A Change in the Price Level (I) AS1 AS2 An increase in AS leads to a decrease in P AS P P1 P2 AD Y1 Y2 © 2004 McGraw–Hill Ryerson Limited A Change in the Price Level (II) A decrease in P leads to a decease in MD which leads to a decrease in r r1 P r2 MD1 MD2 Y © 2004 McGraw–Hill Ryerson Limited MD r A Change in the Price Level (III) A decrease in r leads to an increase in I r r1 r2 ID I1 I2 © 2004 McGraw–Hill Ryerson Limited I A Change in the Price Level (IV) AS1 An increase in I leads to an increase in Y AS2 P1 Summing up: P2 AS up AD => P down P down => r down r down => I up Y1 Y2 © 2004 McGraw–Hill Ryerson Limited I up => Y up Effect of an Increase in Money Supply (I) 1 An increase in the money supply leads to a decrease in the rate of interest 2 Lower rate of interest leads to an increase in investment 3 Since P has not changed, an increase in investment results in a shift in AD to AD2 © 2004 McGraw–Hill Ryerson Limited Effect of an Increase in Money Supply (II) MS1 MS2 r1 r1 r2 r2 ID MD Q1 Q2 I1 P1 AD2 AD1 © 2004 McGraw–Hill Ryerson Limited Y1 Y2 I2 The Monetarist View • Monetarism – An economic school of thought that believes that cyclical fluctuations of GDP and inflation are usually caused by changes in the money supply – GDP determination can be summarized by the equation of exchange © 2004 McGraw–Hill Ryerson Limited Equation Of Exchange (I) • It is a formula that states that the quantity of money (M) times the velocity of money (V) is equal to nominal GDP (price (P) times real GDP (Q)). MV=PQ – Velocity of money ( or velocity of circulation) • The number of times per year that the average unit of currency is spent (or turns over) buying goods and services • The Monetarists believe that V is constant • If we assume full employment and V is constant, any increase in M will have a direct and proportional impact on the price level © 2004 McGraw–Hill Ryerson Limited Equation Of Exchange (II) 1 MV = PQ 2 Nominal GDP = M x V 3 Nominal GDP = P x Q © 2004 McGraw–Hill Ryerson Limited Chapter Summary: What to Study and Remember • Demand for money is not the same as desire for income • There are two types of money demand • The demand for money curve is downward sloping money • Could you explain and illustrate graphically how the money supply and demand affect the equilibrium interest rate? • Describe two views of how the money market affects the level of real GDP and inflation © 2004 McGraw–Hill Ryerson Limited