Macroeconomics Chapter 101 The Demand for Money and the Price Level C h a p t e r 1 0.

Macroeconomics Chapter 10 1

The Demand for Money and the Price Level

C h a p t e r 1 0


Functions of Money

Store of value

Unit of account

Medium of exchange


Concepts of Money

Fiat money has value due to government fiat, rather than through intrinsic value.

Commodity money, such as gold and silver coins, which do have intrinsic value.

High-powered money, which adds the deposits held by banks and other depository institutions

At the Federal Reserve. Another name for high-powered money is the monetary base.


Concepts of Money

Monetary aggregate A monetary aggregate is the total dollar

stock of a group of financial assets defined to be money. The most common definition, called M1

Checkable deposits issued by banks and other financial institutions.


Concepts of Money

Monetary aggregate M2 includes household holdings of

savings deposits, small-time deposits, and retail money-market mutual funds.

The M2 definition goes beyond the concept of money as a medium of exchange.

In our model, it is best to use a narrower definition of money, for example, as currency held by the public.


The Demand for Money

Money is hand-to-hand currency Assume that the interest rate paid on

money is zero. Bonds and ownership of capital

Interest-bearing assets These assets pay a positive return to

the holder.



The household budget constraint in nominal terms

PC + ∆B + P·∆K = π + wL + i · ( B+ PK)

nominal consumption + nominal saving = nominal income



“ demand for money,” Md,

The average holding of money that results from the household’s optimal strategy for money management.



The Interest Rate and the Demand for Money A higher interest rate, i, provides a

greater incentive to hold down average holdings of money, M, in order to raise average holdings of interest-bearing assets, B + PK. That is, with a higher i, households are more willing to incur transaction costs in order to reduce M



The Interest Rate and the Demand for Money We predict that an increase in i reduces

the nominal demand for money, Md.

For a given price level, P, we can also say that a higher i lowers the real demand for money, Md/P.



The Price Level and the Demand for Money Suppose that the price level, P,

doubles. The nominal demand for money, Md, doubles. Since Md and P have both doubled, the ratio, Md/P, is the same.

The result is that the real demand for money, Md/P, does not change when P changes.



Real GDP and the Demand for Money

Assume now that nominal income doubles, while the price level, P, is unchanged.

Households would double their nominal demand for money, Md. Since P is constant, the real demand for money, Md/P, also doubles.



Real GDP and the Demand for Money

Economies of scale in cash management, at higher incomes households hold less money in proportion to their income.



Other Influences on the Demand for Money

Payments technology

The level of transaction costs



The Money-Demand Function

Md = P · L(Y, i)

Md/P = L(Y, i)



Empirical Evidence on the Demand for Money

Steven Goldfeld

Casey Mulligan and Xavier Sala-i-Martin

Michael Dotsey


Determination of the Price Level

The Nominal Quantity of Money Supplied Equals the Nominal Quantity Demanded

Ms = Md

Md = P · L( Y, i)

Key equation: Ms = P· L( Y, i)



Key equation: Ms = P· L(Y, i) Key assumption: Price is flexible.

General equilibrium.

Ms = Md

Ls = Ld

(κK)s = (κK)d



A Change in the Nominal Quantity of Money

From a one-time change in the nominal quantity of money supplied,Ms.

The increase in Ms from M to 2M raises the equilibrium price level from P∗ to 2P∗


Determination of the Price Level A Change in the Nominal Quantity

of Money Since the technology level, A, has not

changed, the real wage rate, w/P, and labor input, L, do not change.

Therefore, the price level, P, is twice as high, and w/P is unchanged. We conclude that, in general equilibrium, the nominal wage rate, w, has to double.


Determination of the Price Level A Change in the Nominal Quantity of

Money The unchanged technology level, A, means that

the real rental price, R/P, and the quantity of capital services, κK, do not change.

The fixed κK corresponds to a given capital stock, K, and an unchanged capital utilization rate, κ.

Thus, the price level, P, is twice as high, and R/P is unchanged. We must have, in general equilibrium, that the nominal rental price, R, doubles.


Determination of the Price Level A Change in the Nominal Quantity

of Money i = (R/P) · κ − δ(κ) .

The doubling of Ms does not change the real rental price, R/P, and the capital utilization rate, κ, the rate of return on ownership of capital does not change on the right hand side of equation

The interest rate, i, is also unchanged



A Change in the Nominal Quantity of Money Y= A· F(κK, L) A doubling of Ms does not affect the

quantities of capital services, κK, and labor, L.

In other words, in general equilibrium, a one-time increase in the nominal quantity of money supplied, Ms, does not affect real GDP.



The Neutrality of Money In the long run, an increase or decrease

in the nominal quantity of money supplied, Ms, influences nominal variables but not real ones.



A Change in the Demand for Money An improvement in the technology for

making financial transactions—perhaps increased use of credit cards or ATM machines—decreases the real demand for money to [L(Y, i)’], so that the nominal demand becomes:

( Md)’ = P · [ L( Y, i)’ ]



A Change in the Demand for Money A decrease in the real demand for

money is similar to an increase in the nominal quantity

Of money supplied in that the price level, P, rises in each case.

However, one difference is that a change in Ms is fully neutral, whereas a change in the real demand for money is not fully neutral.



The Cyclical Behavior of the Price Level A recession,

decline in Y reduces the real quantity of money demanded

The decrease in i raises the real quantity of money demanded

In a recession, the real quantity of money demanded, given by L(Y, i), decreases overall.



The Cyclical Behavior of the Price Level Given nominal quantity of money

supplied, Ms, the decrease in the real quantity of money demanded, L(Y, i), raises the price level, P.

That is P will be countercyclical.


Determination of the Price Level The Cyclical Behavior of the Price Level

In our equilibrium business cycle model, the underlying shocks come from the supply side, not the demand side.

A low technology level, A—the source of a recession in the model—means that goods and services are in low supply.

When looked at this way, it makes sense that P would tend to be high in a recession.



Price-Level Targeting and Endogenous Money When the monetary authority seeks to

attain a specified price level, P, it typically has to adjust the nominal quantity of money, M, in response to changes in the nominal quantity demanded, Md.



Price-Level Targeting and Endogenous Money To see how this works, we now assume

that the monetary authority wants the price level, P to equal a target level P0. This objective is called price-level targeting.



Price-Level Targeting and Endogenous Money

M = P0 · L( Y, i )

nominal quantity of money = price-level target · real quantity of

money demanded



Trend growth of money Since L(Y, i) grows at the same rate as real

GDP, Y, we conclude that M must grow at the same rate as Y. Thereby, the growth rate of the nominal quantity of money, M, matches the growth rate of the real quantity demanded, L(Y, i), and allows the price level, P, to remain constant at its target level, P0.



Price-Level Targeting and Endogenous Money Cyclical behavior of money The cyclical fluctuations in M will match the

cyclical fluctuations in the real quantity of money demanded.

M should be procyclical. Empirically, the nominal quantity of

money, M, is weakly procyclical.



Seasonal variations in money Monetary authority has to vary the

nominal quantity of money, M, to match the changes in the real quantity demanded, L(Y, i), that occur because of economic growth or fluctuations.

An analogous argument applies to the variations in L(Y, i) associated with the seasons.

Macroeconomics Chapter 101 The Demand for Money and the Price Level C h a p t e r 1 0.

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Transcript of Macroeconomics Chapter 101 The Demand for Money and the Price Level C h a p t e r 1 0.