Monetary Policy

Based on “Macroeconomics” by Dornbusch and Fischer and

“Elements of Economics” by Tullao

Definition: Money

Is the means of payment or medium of exchange

More informally, it is whatever is generally accepted in exchange for goods and services

Demand for real balancesPeople hold money for its purchasing

power; for the amount of goods that they can buy with it

People are not concerned with nominal money holdings, that is, the peso/dollar bills they hold

Demand for Money: Theory

Real money demand is unchanged when the price level increases, and all real variables (i.e., interest rate, income, real wealth) remain unchanged

Nominal demand increases in proportion to the increase in the price level, given that the variables specified above remain the same.

Demand for Real Balances: Implications

Keyne’s Motives for Holding (Demand) Money

Transactions Demand for MoneyDemand for money arising from the

use of money in making regular payments

↑real income → ↑TD

↑interest rate → ↓ TD

↑transactions cost → ↑TD

Keyne’s Motives for Holding (Demand) Money

Precautionary Demand for MoneyDemand for money arising to meet

unforeseen contingencies↑probability of being illiquid → ↑PD

↑cost of being illiquid → ↑PD

↑real income → ↑PD

↑interest rate → ↓ PD

Keyne’s Motives for Holding (Demand) Money

Speculative Demand for Money Demand for money that arises from

uncertainties about the money value of other assets that an individual can hold

↑riskiness of returns on other assets → ↑SD

↑real income → ↑SD

↑interest rate → ↓ SD

Empirical Results: The Goldfeld Study

The demand for real money balances responds negatively to the rate of interest.

The demand for money increases with the level of income.

The short-run responsiveness of money demand to changes in interest rates and income is considerably less than the long-run responses.

Income (Y) iTD iCP

Short-run 0.19 -0.045 -0.019

Long-run 0.68 -0.160 -0.067

Elasticities of Real M1 Money

Supply of Money: Components

Currency – coins and notes in circulation M1 Money – currency + claims that can be

directly, instantly, and without restrictions used to make payments

M2 Money – M1 + claims that are not instantly liquid

M3 Money – M2 + large negotiable deposits and repurchase agreements held primarily by corporations and wealthy individuals

The Income Velocity of Money and the Quantity Theory

Income velocity of money Definition: the number of times the stock of

money is turned over per year in financing the annual flow of income

Equal to the ratio of GDP(GNP) to the money stock

v = YN/MS

The Quantity Theory of Money Links the price level and the level of output

to the money stock

Expansionary Monetary Policy (EMP)

↑Ms → ↑C and ↑I → ↑AD → ↑YNopen market operations

• government redeems T-bills/government bonds

reserve requirement (rr)• central bank reduces the reserve

requirementdiscount rate (dr)

• central bank reduces the discount rate

Contractionary Monetary Policy (CMP)

↓Ms → ↓C and ↓I → ↓AD → ↓YNopen market operations

• government sells T-bills/government bonds

reserve requirement (rr)• central bank increases the reserve

requirementdiscount rate (dr)

• central bank increases the discount rate