Money and Real Economy Money Bonds Monetary Policy

Money and Real Economy Money, Bonds, Monetary Policy, GDP 1

§ Money and Bonds § There are many things in the economy § § § § Cash Chequing accounts Saving accounts Treasury bills Bonds Business shares (equity) etc § Simplify § Yields no interest = money § Medium of exchange § Cash § Chequing accounts § Yields interest = bond § Medium of saving 2

§ Discounting § A bond § § Coupon Maturity T Price Yield i § Present value of a bond § Stream of revenues in the future § Discounted future payments § Present value of a stream § In equilibrium, bonds yield market interest rate § The equilibrium market price of a bond = PV of the income stream 3

§ Demand for money = amount of money that everyone in the economy wants to hold § Greater demand for money = lower demand for bonds § Reasons to hold money § Transaction demand § Simplest, M = a. Y § Precautionary demand § Speculative demand § Adjusting portfolio of financial assets § Lower interest rate expected = we expect bond prices will increase = we want more bonds now = we want to hold less money now 4

§ Demand for money, curve § Interest rate is negatively related to the amount of money we want to hold § Interest rate = cost of holding money § MD = MD(i, Y, P) § ∂MD/∂I < 0 § Along the MD curve § ∂MD/∂Y > 0 § Shift in the MD curve § ∂MD/∂P > 0 § Shift in the MD curve 5

§ Monetary equilibrium § Money supply MS is independent of interest rate § Print more money = greater money supply § Let banks create more money = greater money supply § Any of these increase reserves § Monetary equilibrium: MD = MS § Because the bond prices change and so the interest rate changes § This is the liquidity preference theory of interest 6

§ Monetary Transmission Mechanism § Step 1: § The liquidity preference theory of interest: § Increase in MS § Decrease in equilibrium interest rate § Increase in equilibrium quantity of money § Increase in MD § Increase in equilibrium interest rate § No change in equilibrium quantity of money 7

§ Monetary Transmission Mechanism § Step 2: § Decrease in equilibrium interest rate § Increase in desired investments § Demand for investments § Increase in consumption § Big ticket items § Increase in net exports § Capital outflow § Depreciation of Canadian dollar § Domestic goods cheaper than foreign goods § The slope of the AD curve 8

§ Long Run vs Short Run § Short run: § Increase in money supply => § Increase in AD => § Positive AD shock § Long run § Y* = const § Recall, factor prices will adjust § Now can think: § Positive AD shock => P increases => MD increases => interest rate increases 9

§ Long Run vs Short Run § We say § Money are neutral in long run § Means money do not influence real GDP in long run § Money are not neutral in short run § Means money do influence real GDP in short run § This is Classical Dichotomy 10

§ Effectiveness of monetary policy § § MD steep ID flat Monetary policy is effective Monetarists § § MD flat ID steep Monetary policy is ineffective Keynesians 11