Download - 7 Monetary Policy Lecture
Monetary Policy
Based on “Macroeconomics” by Dornbusch and Fischer and
“Elements of Economics” by Tullao
Definition: Money
Is the means of payment or medium of exchange
More informally, it is whatever is generally accepted in exchange for goods and services
Demand for real balancesPeople hold money for its purchasing
power; for the amount of goods that they can buy with it
People are not concerned with nominal money holdings, that is, the peso/dollar bills they hold
Demand for Money: Theory
Real money demand is unchanged when the price level increases, and all real variables (i.e., interest rate, income, real wealth) remain unchanged
Nominal demand increases in proportion to the increase in the price level, given that the variables specified above remain the same.
Demand for Real Balances: Implications
Keyne’s Motives for Holding (Demand) Money
Transactions Demand for MoneyDemand for money arising from the
use of money in making regular payments
↑real income → ↑TD
↑interest rate → ↓ TD
↑transactions cost → ↑TD
Keyne’s Motives for Holding (Demand) Money
Precautionary Demand for MoneyDemand for money arising to meet
unforeseen contingencies↑probability of being illiquid → ↑PD
↑cost of being illiquid → ↑PD
↑real income → ↑PD
↑interest rate → ↓ PD
Keyne’s Motives for Holding (Demand) Money
Speculative Demand for Money Demand for money that arises from
uncertainties about the money value of other assets that an individual can hold
↑riskiness of returns on other assets → ↑SD
↑real income → ↑SD
↑interest rate → ↓ SD
Empirical Results: The Goldfeld Study
The demand for real money balances responds negatively to the rate of interest.
The demand for money increases with the level of income.
The short-run responsiveness of money demand to changes in interest rates and income is considerably less than the long-run responses.
Income (Y) iTD iCP
Short-run 0.19 -0.045 -0.019
Long-run 0.68 -0.160 -0.067
Elasticities of Real M1 Money
Supply of Money: Components
Currency – coins and notes in circulation M1 Money – currency + claims that can be
directly, instantly, and without restrictions used to make payments
M2 Money – M1 + claims that are not instantly liquid
M3 Money – M2 + large negotiable deposits and repurchase agreements held primarily by corporations and wealthy individuals
The Income Velocity of Money and the Quantity Theory
Income velocity of money Definition: the number of times the stock of
money is turned over per year in financing the annual flow of income
Equal to the ratio of GDP(GNP) to the money stock
v = YN/MS
The Quantity Theory of Money Links the price level and the level of output
to the money stock
Expansionary Monetary Policy (EMP)
↑Ms → ↑C and ↑I → ↑AD → ↑YNopen market operations
• government redeems T-bills/government bonds
reserve requirement (rr)• central bank reduces the reserve
requirementdiscount rate (dr)
• central bank reduces the discount rate
Contractionary Monetary Policy (CMP)
↓Ms → ↓C and ↓I → ↓AD → ↓YNopen market operations
• government sells T-bills/government bonds
reserve requirement (rr)• central bank increases the reserve
requirementdiscount rate (dr)
• central bank increases the discount rate