mishkin ch 19
TRANSCRIPT
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Chapter 19
The Demand
for Money
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M= the money supply
P =price level
Y = aggregate output (income)P Y aggregate nominal income (nominal GDP)
V = velocity of money (average number of times per year that a dollar is spent)
V P Y
MEquation of Exchange
M V P Y
Velocity of Money
and Equation of Exchange
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Quantity Theory
Velocity fairly constant in short run
Aggregate output at full-employment
level Changes in money supply affect only
the price level
Movement in the price level resultssolely from change in the quantityof money
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Divide both sides byV
M =1
VPY
When the money market is in equilibrium
M = Md
Let k 1
V
Md k PY
Because kis constant, the level of tranactions generated by a
fixed level ofPYdetermines the quantity ofMd
The demand for money is not affected by interest rates
Quantity Theory of Money Demand
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Keyness Liquidity Preference Theory
Transactions Motive
Precautionary Motive
Speculative Motive
Distinguishes between real and nominal
quantities of money
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Md
P f(i,Y) where the demand for real money balances is
negatively related to the interest rate i,
and positively related to real income Y
Rewriting
P
Md
1
f(i,Y)
Multiply both sides by Yand replacingMdwithM
V PY
M
Y
f(i,Y)
The Three Motives
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The procyclical movement of interest rates should induce
procyclical movements in velocity
Velocity will change as expectations about future normallevels of interest rates change
The Three Motives (contd)
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There is an opportunity cost and benefitto holding money
The transaction component of the demand formoney is negatively related to the level ofinterest rates
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Precautionary Demand
Similar to transactions demand
As interest rates rise, the opportunity
cost of holding precautionarybalances rises
The precautionary demand for money is
negatively related to interest rates
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Speculative Demand
Implication of no diversification
Only partial explanations
developed further Risk averse people will diversify
Did not explain why money is held as a
store of wealth
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( , , , )
=demand for real money balances
= meausre of wealth (permanent income)
= expected return on money
= expected return on bonds= expected return on equity
= expected
de
p b m e m m
d
p
m
b
e
e
Mf Y r r r r r
P
M
P
Y
r
rr
inflation rate
Friedmans
Modern Quantity Theory of Money
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Variables in
the Money Demand Function
Permanent income (average long-run income) is
stable, the demand for money will not fluctuate much
with business cycle movements
Wealth can be held in bonds, equity and goods;incentives for holding these are represented by the
expected return on each of these assets relative to the
expected return on money
The expected return on money is influenced by: The services proved by banks on deposits
The interest payment on money balances
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Differences between Keyness and
Friedmans Model
Friedman
Includes alternative assets to money
Viewed money and goods as substitutes
The expected return on money is not
constant; however, rbr
mdoes stay
constant as interest rates rise Interest rates have little effect on the
demand for money
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Differences between Keyness and
Friedmans Model (contd)
Friedman (contd)
The demand for money is stable
velocity is predictable Money is the primary determinant of
aggregate spending
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Empirical Evidence
Interest rates and money demand Consistent evidence of the interest sensitivity of the
demand for money
Little evidence of liquidity trap Stability of money demand
Prior to 1970, evidence strongly supported stabilityof the money demand function
Since 1973, instability of the money demandfunction has caused velocity to be harder to predict
Implications for how monetary policy shouldbe conducted