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Chapter 10 The Demand for Money and the Price Level Concepts of Money Fiat money No intrinsic value; The face value is enforced by the government; No interest paid. Levels of aggregation Monetary base Currency held by the public; Currency held by banks. M1 Currency held by the public; Checkable deposits. The Demand for Money The use of household income PC+M+B+PK=+wL+i(B+PK) Money v.s. other assets: not interest-bearing. Households could allocate their assets toward interest-bearing types by minimizing their money balances. Why hold money? For convenience. Trade off between interest earnings and daily transaction costs. The Demand for Money The interest rate Higher interest ratehigher opportunity cost of holding moneyMd/P decreases. The price level Real income remain unchanged; Md/P remain unchanged. Real income Higher real incomemore transaction needs Md/P increases; Md/P may increase less than proportionally. The Demand for Money The money demand function Md L( Y , i ) P ( ) ( ) Determination of the Price level Ms is exogenously set by the central bank. Equilibrium condition Ms=PL(Y, i) P is determined by the equilibrium condition on the money market. Other nominal prices adjust quickly to clear markets Labor market: w; Rental market: R. Determination of the Price level Determination of the Price level A Change in the Nominal Quantity of Money At the new equilibrium, Y and i are unaffected; Md curve remain unchanged; P varies in proportion to Ms. w/P remain unchangedw varies in proportion to P. R/P remain unchangedR varies in proportion to P. i=(R/P)- remain unchanged. Y remain unchanged. Determination of the Price level A Change in the Nominal Quantity of Money Determination of the Price level The Neutrality of Money All real terms remain unchanged. K, , L, Y, w/P, R/P, i. Nominal prices vary in proportion to Ms. P, w, R. Non-nerutal money Nominal prices are sticky in the short-run. Determination of the Price level A Change in the Demand for Money Real demand for money decreased; The money demand curve rotates counterclockwisely; P increased; Real terms unaffected. Determination of the Price level A Change in the Demand for Money Determination of the Price level The Cyclical Behavior of the Price Level Recession: lowers Y and i; YL(Y, i) iL(Y, i) Empirical evidence suggests that the first effect is stronger. P is countercyclical. The source of business cycles is the supply side Less goods bid for money during recession. Cyclical Behavior of U.S. Real GDP and the Price Level Price-Level Targeting and Endogenous Money Ms may respond to economic events. Price-level targeting: P P Determination of nominal money supply M PL(Y , i) Trend growth of money Y is growing in the long run; Price-level targeting requires that Ms grows accordingly. Price-Level Targeting and Endogenous Money Cyclical behavior of money RBC theory suggests that Y and i are procyclical; Money demand is more responsive to Y than to i; L(Y, i) is procyclical; Price-level targeting requires that M be procyclical; M is empirically weakly procyclical; The policy has weakened the countercyclical pattern of P.