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CHAPTER 7 MONEY DEMAND & MONEY SUPPLY

7.1 Keynesian Theory Of Money Demand (Md) A. Assumption It is assumed that there are only 2 types of financial asset : (1) Money It is perfectly liquid financial asset, but earns no . (2) Bonds It is less liquid but earn returns. All bonds are assumed to be perpetuities  the price/market value of bond : Pb =  when r falls (given a fixed interest payment), Pb Hence r and Pb are related. B. Motives for holding money (1) motive/demand (Mt) There is time gap between receipt and expenditure  hold money to make transactions i.e., to finance day-to-day purchases of goods and services. Mt = (2)

motive/demand (Mp) People hold money for precautionary purposes against unexpected circumstances e.g. receipts of income were delayed. Mp = **In a new approach to the Md, the Mp is incorporated into Mt and therefore becomes a function of income i.e., Mt = and is independent of r.

(3)

motive/demand (Msp) - Msp is due to speculation about possible changes in the . When the current r is relatively low (current Pb is ); people are likely to expect the r to rise (that means future Pb will )  people expect that the capital loss will be than the fixed interest income  would prefer holding more rather than . 1

 Msp is related to r. **According to Keynesian, if the current rate of interest is very low, people will believe that it is the minimum r and they would all hold their financial assets in  the Md curve ( = Mt + Msp) may be perfectly at a certain low interest rate. This perfectly elastic portion of Md curve is called the (p.130) ** In a new approach Msp is treated as demand for money (Ma) Holding financial assets as money provides the owners with , in nominal value and reduced , but it involves the opportunity cost of forgone income.  the higher the opportunity cost (r), the lower the amount of Ma  Ma is related to r. C. The demand curve for money Refer to p.127, fig.4 D. Factors affecting demand for money (p.128) Even Y remains unchanged, there are other factors affecting Md. (1) The frequency of receipt of income by household (pay period) frequency  time lag between income inflows  the the tendency for money expenditure cannot meet the receipt  the amount of money needed for transaction purpose. (2) The use of credit cards If more people use credit cards as a medium of exchange, the amount of transactions balances they hold will . (3) Vertical integration More internal transactions  are needed.

market transactions 

transactions balances

(4) Liquidity preference (prefer highly liquid asset) If future seems uncertain  hold money and bonds (since repayment is not sure). 7.2 Supply Of Money (Ms) (p.130) (1) Endogenous Ms 2

(2) Exogenous Ms 7.3 Equilibrium In The Money Market r is determined by the intersection of the and curves, i.e., = - When there is excess Md  bonds and convert them into  Pb  r until Md = Ms - When there is excess Ms  bonds  Pb  r until Md = Ms 7.4 Monetary Policy (p.133) The control of Ms and r to achieve certain goals, e.g. high stability, in the economy.

,

(1) Expansionary (used when there is high ) (a) Ms as Ms  people hold more money than they want at the going r  spend more on buying goods and services  AD  Q to Qf (b) r as r  I, C  AD  Q to Qf (2) Contractionay (used when there is high (a) Ms as Ms  people hold spend on buying  AD  P (b) r as r  I, C  AD  P

) 

Remarks : To Keynes, change in Ms will first have impact on the market rather than goods market (AD). E.g. When Ms rises  people hold more money than they want at the going r  spend on buying  Pb  r  I  AD/AE Q/Y . The above is called the Keynesian money transmission mechanism. (3) Methods to control Ms (a) Varying the required reserve ratio 3

(b) Varying the discount rate

(c) Open market operations

(d) Moral suasion

(e) Printing more money (4) Effectiveness of monetary policy (a) Existence of excess (b)

flows

(c)

from other countries

(d) Moral

may not be effective

(e) Time (f) Problem of

assets

7.5 The Quantity Theory Of Money (p.139) This can be used to explain how the economy reacts to changes in the Ms. (1) The velocity of circulation Consider that : An economy produced 20 apples (T) annually, each being priced at $5 (P). This economy’s money stock is $10 (M). In order to finance the transactions of buying and selling the 20 apples, each dollar of the M should circulate times ( ) in the economy. This is called the velocity of circulation (V). …………(a) The volume of transactions T can be written as Q (the real output) : …………(b) 4

(2) The equation of exchange (by Irving Fisher) and the quantity equation of money (i) By rearranging (a), we get the equation of exchange (Fisher’s equation) (It is an

, that means they must always be equal. )

(ii) By rearranging (b), we get the quantity equation of money (It is an

, too.)

(3) The quantity theory of money To make the equation become a useful theory, some assumptions have to be made : (i) V is regarded as more or less constant. (ii) Q is regarded as more or less constant (assuming the economy is at its fullemployment level). (iii) Ms is exogenously determined.  =  as M , P (4) The Cambridge version (i) It concentrates on the factors that determine the demand for money. (ii) It assumes that people’s Ms is for motive only. People keep a certain amount of money balances in proportion of their . Md = In fact, this equation is from : Remarks : (a) Relationship between k and V

(b) Relationship between Ms and V

(5) The transmission mechanism (Explanation for the rise in P when M increases, keeping V/k and Q constant.) When Ms increases  people hold

money that they want at the going r 5

 for an individual, he can spend the excess money on buying goods and services without affecting the . However, if all individuals in the economy do this, P would be .

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