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Notes

Beyond the expression, other factors affecting money demand include: - Wealth increases money demand slightly, while increased risk in the economy increases it but erratic inflation decreases it due to risk to money. During erratic inflation, gold is a better investment. - Financial innovations like credit cards and ATMs have increased liquidity of other assets, reducing money demand. - Payment technologies reduce money demand through alternatives like credit cards and ATMs.

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45 views2 pages

Notes

Beyond the expression, other factors affecting money demand include: - Wealth increases money demand slightly, while increased risk in the economy increases it but erratic inflation decreases it due to risk to money. During erratic inflation, gold is a better investment. - Financial innovations like credit cards and ATMs have increased liquidity of other assets, reducing money demand. - Payment technologies reduce money demand through alternatives like credit cards and ATMs.

Uploaded by

bousry.meryem
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Beyond the expression, other factors affecting money demand

- Wealth: A rise in wealth may increase money demand, but not by much
- Risk
o Increased riskiness in the economy may increase money demand
o But times of erratic inflation bring increased risk to money, so money demand
declines
 What is the best strategy for the case erratic inflation, buy gold (the
commodity money)
- Liquidity of alternative assets: Deregulation, competition, and innovation have given
other assets more liquidity, reducing the demand for money
- Payment technologies: Credit cards, ATMs, and other financial innovations reduce money
demand

Assumptions
- Assume that all assets can be grouped into two categories, money and nonmonetary
assets
o Money includes currency and checking accounts
 Pays interest rate im
 Supply is fixed at M
o Nonmonetary assets include stocks, bonds, land, etc.
 Pays interest rate i = r + pie
 Supply is fixed at NM

Derivation 1
- md + nmd = total nominal wealth of an individual
- Md + NMd = aggregate nominal wealth (from adding up individual wealth) Eq. (1)
- M + NM = aggregate nominal wealth (supply of assets) Eq. (2)
- Subtracting Eq. (2) from Eq. (1) gives (Md – M) + (NMd – NM) = 0

Derivation 2
Md – M = NM = NMd  If Md = M then NMd = NM
- If the demand of money equal the supply of money then the demand of nonmonetary
assets equal the supply of nonmonetary assets
- The asset market equilibrium (both the market for money and the market for
nonmonetary assets are simultaneously at equilibrium) can be represented by the money
market equilibrium
- M/P = L(Y, r+pie): Real Money Supply = Real Money Demand
- M = P x L(Y, r+pie): Nominal Money Supply = Nominal Money Demand

Asset Market Equilibrium


- For the asset market equilibrium, the price is the P and the quanitity is nominal money
supply M or real money demand L
- Given money supply (controlled by the central bank), we can solve the price level from P
= M / L(Y, r + pie)
- The price level is the ratio of nominal money supply to real money demand
- For example, doubling the money supply would double the price level (other things
fixed)

Extra Credit
- Suppose the Fed raises the federal fund rate, how does this affects the asset market
equilibrium (affect the price, and real demand/supply)?

Money Growth and Inflation


- The inflation rate is closely related to the growth rate of the money supply
o Delta P/P = Delta M/M – Delta L (Y, r + pie)/L(Y, r+pie)
o If the asset market is in equilibrium, the inflation rate equals the growth rate of the
nominal money supply minus the growth rate of real money demand

How to predict inflation?


- To predict inflation we must forecast both money supply growth and real money demand
growth
o In long-run equilibrium, we will have I constant (if the economy is at a balanced
growth path, both r and pie are constant), so we are left with the growth in Y
o Ley ny be the elasticity of money demand with respect to income, the effect of Y
growth on real money demand is nyDelta Y/Y
o Then we have,
 Pi = Delta M/M – nyDelta Y/Y

Q: if we have Delta Y/Y = 3%, ny = 2/3, Delta M/M = 10%, what is pi


- A. 10%
- B. 2%
- C. 8%
- D. 12%

Take a one step back, how did we find expected inflation


- For a given real interest rate (r), expected inflation (pie) determines the nominal interest
rate ( i = r + pie)
- What determines expected inflation?
o The expected inflation rate would equal the current inflation rate if money growth
and income growth were stable (we are at a balanced growth path)
o If people expect an increase in money growth (greater than previous growth), they
would then expect a commensurate increase in the inflation rate
o We can measure the expectation using surveys, or we can imply it from the
nominal interest rate (pie = i − r) assuming that expected real interest rate is
unchanged over time

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