December 23 2011

Macroeconomics

2

Demand for Money

Aggregate Supply

3

»What is money and why do people want it?

»Medium of exchange

»Store of value

»Income

»Wealth

»Why do firms/individuals hold money?

»What assets constitute money?

Aggregate Supply

4

»What is money and why do people want it?

»Medium of exchange

»Store of value

»Income

»Wealth

»Why do firms/individuals hold money?

»What assets constitute money?

Components of Money Stock

5

»Currency

»Demand Deposits

»Traveler’s checks (non-banks)

»Other checkable deposits

»MMMFs

»MMDAs

»Savings by deposits

»Small time deposits

Components of Money Stock

6

»Repurchase Agreements (RP)

»Eurodollars

»Large denomination time deposits

»Institutional holdings of MMMFs

»Savings Bonds

»Banker’s acceptances

»Commercial Paper

»Short-term Treasury Securities

Components of Money Stock

7

»M1 = Currency + DD + TCs + Other

checkable deposits

»M2 = M1 + MMMFs + MMDAs + Savings

Deposits + Small time deposits

»M3 = M2 + RPs + Eurodollars + Large

denomination TDs + Institutional holdings

of MMMFs

»M4 = M3 + Savings bonds + Banker’s

acceptances + CPs + Treasury securities

Functions of money

8

»Store of value

»Asset that maintains value over time

»Makes purchases at a future date

»Unit of account

»Unit in which prices are quoted and

books kept

»For high-inflation countries, dollars serve

as the unit of account

Functions of money

9

»Standard of deferred payment

»Asset that is used in long-term

transactions such as loans

»Indexed loans

»Money is usually whatever is generally

accepted in exchange – if sea shells work,

so be it!

»Money is accepted only because it would be

accepted by others later

Demand for Money

10

»Demand for money is a demand for real

balances

»Real money demand is unchanged when

price level increases

»Nominal money demand increases in

proportion to the increase in price level

»3 motives for holding money: Transactions

motive, precautionary motive, speculative

motive

Demand for Money

11

»Demand for money is a demand for real

balances

»Real money demand is unchanged when

price level increases

»Nominal money demand increases in

proportion to the increase in price level

»3 motives for holding money: Transactions

motive, precautionary motive, speculative

motive

Income Velocity of Money

12

»Number of times the stock of money is

turned over per year in financing the annual

flow of income

»Ratio of nominal GDP to nominal money

stock

»Income Velocity:

»V = (P x Y)/M = Y/(M/P)

»What does high velocity indicate?

Quantity Theory of Money

13

»M x V = P x Y

»Equation links price level and the level of

output to money stock

»‘Classic’ economists’ view: Economy was at

full employment and real output was fixed;

velocity was expected to be stable

»What happens if ‘V’ an ‘Y’ are fixed?

»Theory of inflation

14

Aggregate Supply Analysis – Classical View

Aggregate Supply

15

»Role of Aggregate Demand in determining

the economy’s output

»What does the AD curve signify?

»What is Aggregate Supply and how does the

curve look like?

»Combinations of output and the price level

at which firms are willing, at the given price

level, to supply the given quantity of output

Aggregate Supply curve

16

»Classical Supply curve:

»Vertical – indicating that the same

amount of goods will be supplied

whatever be the price level

»Assumption: Labor market equilibrium

»Long term possibility

»Why should supply curve be vertical in

long run? Recall how it was in

microeconomics!

Production Function

17

»Technological relation between the rates of

input of productive resources and the

maximum rate of output that can be had

from the inputs, given the technology of

production

»Example?

»What does production function mean in the

microeconomic context?

»Y = f(K, N)

Production Function

18

»Output’s relationship to capital stock and

labor employed?

»Recall diminishing returns!

»Assumption for the model: Constant capital

stock and technology

»New production function: Y = f(N)

»The production function graph

»Reason why the slope reduces?

Demand for Labor Function

19

»Assumption: Given capital stock, pure

competition

»Demand for labor curve consists of the MP

of labor curve

»The condition of W = P * MPL

»Cost of hiring an additional worker vis-à-vis

the revenue associated with the

employment of the additional laborer

Demand for Labor Function

20

»W/P = MPL

»To obtain the demand curve, the

relationship between real wage and the

amount of labor is used

»Slope of the production function

»Downward sloping demand curve for labor:

ND = f(W/P)

»Shifts in demand for labor

Supply of Labor Function

21

»Real wages play a key role!

»NS = f(W/P)

»Relationship between real wages and labor

supplied

Summary of labor demand and supply

22

»Production is entirely a function of the quantity

of labor: Y = f(N)

»Amount of labor supplied depends only on real

wage and increases with real wage

»Amount of labor demanded also depends only

on real wage rate and decreases with it

»Real wages perfectly flexible (“flex price”)

»Economy is made up of efficiently operating

markets that are very flexible (ND = NS = N)−

Keynesian Aggregate Supply Model

23

»Criticism of assumptions made in Classical

model

»Similarity of views on Aggregate Production

Function and demand for labor

»Keynesian Assumptions:

»Nominal wage is exogenous (No rapid

adjustment)

»Labor market is not always in equilibrium

Classical Analysis of Income Determination

24

»Say’s Law of Markets: Supply creates its own

demand

»Exchange between parties involves two

transactions of the counteractive nature

»No overproduction of goods

»Possibility of preference of total output

surpassing total demand

»Extension of this theory: Money is not preferred

for money!

Equilibrium in the Classical Model

25

»Economy consists of 3 markets: Labor, money

and goods

»Labor Market:

»Y = f(N)

»dY/dN = W/P

»ND = f(W/P)

»NS = f(W/P)

»ND = NS

Equilibrium in the Classical Model

26

»Money Market:

»M = KPY

»Goods Market:

»S = f(r)

»I = f(r)

»S = I

27

Case Discussion – Should Energy be Subsidized?

Questions???

Have a happy Sunday!