Syllabus

Lecutres

Outlines

Assignments

Altimate Goal:
To show that in the long-run,
1. Price level is proportionally related to the amount of money stock in the economy;
2. Inflation rate is proportionally related to the growth of money stock in the economy.

Method:
1. Start with the asset market
2. Divide the asset market into two markets:
a. Market for monetary assets (Money market), and
b. Market for non-monetary assets: gold, real estate, stock, bond, …
c. Equilibrium in money market implies equilibrium in the asset market.

3. Concentrate on the money market:
a. Money and its functions
b. Money supply measurement
c. Money demand determination:
· The portfolio approach (money as an asset)
· The liquidity preference approach (money as a medium of exchange)

d. State the long-run equilibrium in the money market
· Money supply and the price level
· Growth in money supply and the inflation rate

Lecture Outline

I. What Is Money?
A. Functions of money
1. Medium of exchange
a. Barter is inefficient - it requires a double coincidence of wants
b. Use of money
· eliminates double coincidence of
· reduces transactions costs of trade (value of time)
· allows specialization. Since trading is easier, people do not have to be self-sufficient

2. Unit of account
a. Money is the unit of measuring value
b. Simplifies comparisons of prices and wages
c. Reduces information costs (cost of gathering information)

3. Store of value
a. People may hold part of their wealth in money.
b. This is usually for small amounts and short time period.
c. Advantage of money: the most liquid asset
d. Disadvantage: Inflation reduces its value.

A. Measuring money - the monetary aggregates
1. Distinction between money and non-money assets sometimes difficult
a. Example: Are MMMFs money?
b. No single best measure of money

2. The M1 monetary aggregate
a. Used for making payments; the closest money measure to its theoretical description
b. Currency + traveler's checks + demand deposits + other checkable-type deposits

Monetary Aggregates

2001.09

M1 $1194 B
Currency 44%
Travelers' Checks 1%
Demand Deposits 33%
Other Checkable deposits 22%

M2 $5398 B
M1 24%
Savings deposits + MMDA 38%
Small-denomination TD 20%
MMMFs (non-institutional) 17%

M3 $7821 B

3. The M2 monetary aggregate
a. M2 = M1+less money-like assets
b. savings deposits, small denomination (<$100,000) time deposits, MMDAs

4. Other monetary aggregates
M3 and L

B. The Money Supply (M)
1. Money supply (or stock) = amount of money available in the economy
2. The Fed controls the money supply through Open Market Operation

II. Money Demand:
A. Demand for money as an asset
The amount of money people hold in their asset portfolio depends on:

1. The expected return on money relative to other assets
2. Risk of return on money relative to other assets
3. Liquidity of money relative to other assets
4. Wealth

B. Demand for money as a medium of exchange
The amount of money people hold to carry out transactions depends on:

1. The price level (P)
2. The volume of transactions, measured by the size of real income (Y)
3. The opportunity cost of holding money = nominal interest rate on alternative assets (i)
4. Note: i = r + pe where r is the real interest rate determined by the amount of S and I.

C. Money Demand Function:

Md = P. L(y, i) (1)
Or
Md = P. L(y, r + pie) (2)

Md = nominal money demand
P = price level
L= real money demand function
Y = real income
i = nominal interest rate on non-monetary assets

1. Md and P are proportionally related
2. A rise in y will increase Md
3. A rise in i will reduce Md
4. A rise in r or pe will reduce Md

Real Money demand function:
Md/P = L(y, r + pie) (3)

Summary of factors that affect money demand:

1. Wealth
2. Risk of return on money relative to other assets
3. Liquidity of money relative to other assets
4. Expected rate of return on money relative to other assets
5. Real income
6. The price level
7. Real interest rate
8. Expected inflation

III. Money market Equilibrium

A. Quantity of Real Money Supplied = quantity of real money demanded

M/P = L(y, r + pie) (5)

or P = M / L(y, r + pie) (6)

Equilibrium condition involves 5 variables:
1. M: set by the central bank
2. Y: determined by production technology and the amount of K, N, and A
3. r : determined by saving and investment in the economy
4. pe: which we assume fixed for the time being

B. Money Supply and the price level

1. The price level is the ratio of nominal money supply M and real money demand L(y, r + pie)
2. A change in M has no effect on y, r, and pie. Thus, it should affect the price level.
3. A doubling of M would double P

C. Money Growth and Inflation

DM/M = DP/P + D L(y, r + pie)/ L(y, r + pie) (7)

or DP/P = DM/M - D L(y, r + pie)/ L(y, r + pie) (8)

Inflation equals growth in nominal money supply minus growth in real money demand

If in the long-run, growth in income is the only cause of growth in real money demand, then,

DP/P = DM/M - Ey Dy/y

Ey = income elasticity of money demand,
Dy/y = growth in real income.

Above equation can also be used to forecast future inflation. To do so, we need future forecasts of money growth, income growth, and income elasticity of money demand.

D. Velocity
1. Velocity: # of times money stock is used in transactions.
2. Let V = velocity, Y = Volume of transactions,
P = price of goods, and M = nominal money stock. Then

V = P.Y/M = Nominal GDP / money stock

3. Quantity Theory of Money
a. Classical theory of money demand
b. Money market equilibrium: Md/P =Ms/P
c. Then Md/P = Y/V
d. Classical Assumption: constant long-run V
Let k = 1/V
Then Md/P = k.Y
Quantity Theory: Real demand for money depends only on real income and does not depend on nominal interest rate.

Question: Is velocity constant?

M1 velocity is not
M2 is relative stable in the long-run.