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Chapter10
The Demand for Money and
the Price Level
Macroeconomics Chapter 10
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Macroeconomics Chapter 10
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Concepts of Money
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Fiat money has value due to government
fiat, rather than through intrinsic value.
Commodity money, such as gold and
silver coins, which do have intrinsic value.
High-powered money, which adds the
deposits held by banks and other
depository institutions
At the Federal Reserve. Another name for
high-powered money is the monetary
base.
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Concepts of Money
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Monetary aggregate
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A monetary aggregate is the total
dollar stock of a group of financial
assets defined to be money. The most
common definition, called M1
Checkable deposits issued by banks
and other financial institutions.
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Concepts of Money
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Monetary aggregate
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M2 includes household holdings of
savings deposits, small-time deposits,
and retail money-market mutual funds.
The M2 definition goes beyond the
concept of money as a medium of
exchange.
In our model, it is best to use a
narrower definition of money, for
example, as currency held by the public.
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The Demand for Money
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Money is hand-to-hand currency
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Assume that the interest rate paid on
money is zero.
Bonds and ownership of capital
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Interest-bearing assets
These assets pay a positive return to
the holder.
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The Demand for Money
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The household budget constraint in
nominal terms
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PC + ∆B + P·∆K = π + wL + i · ( B+ PK)
nominal consumption + nominal saving =
nominal income
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The Demand for Money
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“demand for money,” Md,
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The average holding of money that
results from the household’s optimal
strategy for money management.
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The Demand for Money
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The Interest Rate and the Demand
for Money
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A higher interest rate, i, provides a
greater incentive to hold down average
holdings of money, M, in order to raise
average holdings of interest-bearing
assets, B + PK. That is, with a higher i,
households are more willing to incur
transaction costs in order to reduce M
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The Demand for Money
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The Interest Rate and the Demand
for Money
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We predict, accordingly, that an
increase in i reduces the nominal
demand for money, Md.
For a given price level, P, we can also
say that a higher i lowers the real
demand for money, Md/P.
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The Demand for Money
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The Price Level and the Demand for
Money
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Suppose that the price level, P, doubles.
The nominal demand for money, Md,
doubles. Since Md and P have both
doubled, the ratio, Md/P, is the same.
The result is that the real demand for
money, Md/P, does not change when P
changes.
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The Demand for Money
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Real GDP and the Demand for Money
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Assume now that nominal income doubles,
while the price level, P, is unchanged.
Households would double their nominal
demand for money, Md. Since P is
constant, the real demand for money,
Md/P, also doubles.
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The Demand for Money
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Real GDP and the Demand for
Money
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Economies of scale in cash
management, at higher incomes
households hold less money in
proportion to their income.
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The Demand for Money
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Other Influences on the Demand for
Money
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Payments technology
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The level of transaction costs
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The Demand for Money
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The Money-Demand Function
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Md = P · L(Y, i)
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Md/P = L( Y, i)
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The Demand for Money
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Empirical Evidence on the Demand
for Money
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Steven Goldfeld
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Casey Mulligan and Xavier Sala-i-Martin
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Michael Dotsey
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Determination of the Price Level
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The Nominal Quantity of Money Supplied
Equals the Nominal Quantity Demanded
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Ms = Md
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Md = P · L( Y, i)
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Key equation:
Ms = P· L( Y, i)
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Determination of the Price Level
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General equilibrium.
 Ms
 Ls
= Md
= Ld
 (κK)s
= (κK)d.
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Determination of the Price Level
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Determination of the Price Level
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A Change in the Nominal Quantity
of Money
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From a one-time change in the nominal
quantity of money supplied,Ms.
The increase in Ms from M to 2M raises
the equilibrium price level from P∗ to
2P∗
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Determination of the Price Level
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Determination of the Price Level

A Change in the Nominal Quantity
of Money
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Since the technology level, A, has not
changed, the real wage rate, w/P, and
labor input, L, do not change.
Therefore, the price level, P, is twice as
high, and w/P is unchanged. We
conclude that, in general equilibrium,
the nominal wage rate, w, has to
double.
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Determination of the Price Level
A Change in the Nominal Quantity of
Money
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The unchanged technology level, A, means that
the real rental price, R/P, and the quantity of
capital services, κK, do not change.
The fixed κK corresponds to a given capital
stock, K, and an unchanged capital utilization
rate, κ.
Thus, the price level, P, is twice as high, and
R/P is unchanged. We must have, in general
equilibrium, that the nominal rental price, R,
doubles.
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Determination of the Price Level

A Change in the Nominal Quantity
of Money
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i = (R/P) · κ − δ(κ) .
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The doubling of Ms does not change the
real rental price, R/P, and the capital
utilization rate, κ, the rate of return on
ownership of capital does not change on
the right hand side of equation
The interest rate, i, is also unchanged
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Determination of the Price Level

A Change in the Nominal Quantity
of Money
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Y= A· F(κ K, L)
A doubling of Ms does not affect the
quantities of capital services, κK, and
labor, L.
In other words, in general equilibrium,
a one-time increase in the nominal
quantity of money supplied, Ms, does
not affect real GDP.
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Determination of the Price Level
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The Neutrality of Money
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In the long run, an increase or
decrease in the nominal quantity of
money supplied, Ms, influences nominal
variables but not real ones.
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Determination of the Price Level
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A Change in the Demand for Money
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An improvement in the technology for
making financial transactions—perhaps
increased use of credit cards or ATM
machines—decreases the real demand
for money to [L(Y, i)’], so that the
nominal demand becomes:
( Md)’ = P · [ L( Y, i)’ ]
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Determination of the Price Level
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Determination of the Price Level
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A Change in the Demand for Money
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A decrease in the real demand for
money is similar to an increase in the
nominal quantity
Of money supplied in that the price
level, P, rises in each case.
However, one difference is that a
change in Ms is fully neutral, whereas a
change in the real demand for money
is not fully neutral.
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Determination of the Price Level
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The Cyclical Behavior of the Price
Level
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A recession,
decline in Y reduces the real quantity of
money demanded
 The decrease in i raises the real quantity
of money demanded
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In a recession, the real quantity of
money demanded, given by L(Y, i),
decreases overall.
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Determination of the Price Level
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The Cyclical Behavior of the Price
Level
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Given nominal quantity of money
supplied, Ms, the decrease in the real
quantity of money demanded, L(Y, i),
raises the price level, P.
That is P will be countercyclical.
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Determination of the Price Level
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Determination of the Price Level
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The Cyclical Behavior of the Price Level
 In our equilibrium business cycle model,
the underlying shocks come from the
supply side, not the demand side.
 A low technology level, A—the source of
a recession in the model—means that
goods and services are in low supply.
 When looked at this way, it makes sense
that P would tend to be high in a
recession.
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Determination of the Price Level
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Price-Level Targeting and
Endogenous Money
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When the monetary authority seeks to
attain a specified price level, P, it
typically has to adjust the nominal
quantity of money, M, in response to
changes in the nominal quantity
demanded, Md.
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Determination of the Price Level
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Price-Level Targeting and Endogenous
Money
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To see how this works, we now assume
that the monetary authority wants the
price level, P to equal a target level P0.
This objective is called price-level
targeting.
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Determination of the Price Level
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Price-Level Targeting and Endogenous
Money
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M = P0 · L( Y, i )
nominal quantity of money =
price-level target · real quantity of
money demanded
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Determination of the Price Level
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Price-Level Targeting and Endogenous
Money
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Trend growth of money
 Since L(Y, i) grows at the same rate as
real GDP, Y, we conclude that M must grow
at the same rate as Y. Thereby, the growth
rate of the nominal quantity of money, M,
matches the growth rate of the real
quantity demanded, L(Y, i), and allows the
price level, P, to remain constant at its
target level, P0.
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Determination of the Price Level
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Price-Level Targeting and Endogenous
Money
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Cyclical behavior of money
The cyclical fluctuations in M will match the
cyclical fluctuations in the real quantity of
money demanded.
M should be procyclical.
 Empirically, the nominal quantity of money,
M, is weakly procyclical.
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Determination of the Price Level

Price-Level Targeting and Endogenous
Money
 Seasonal variations in money
Monetary authority has to vary the
nominal quantity of money, M, to match
the changes in the real quantity
demanded, L(Y, i), that occur because of
economic growth or fluctuations.
 An analogous argument applies to the
variations in L(Y, i) associated with the
seasons.
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