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MonetaryTheory

What determines the demand for

money?Effects of changes in money supply.Channels of influence of monetary

policy

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Money Supply andEconomic Activity

How do changes in money supply affect

the economy? Short-run analysis: price level fixed,

output below the economys capacity

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Velocity of Circulation

Equation of exchangeMV = PY

M - money supplyV - velocity of circulation

P - price levelY - real gross national product Its an IDENTITY

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Effects of increase in money

supply One or more of

rise in real output rise in prices fall in velocity of circulation

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Demand for Money

Equilibrium: demand for money mustequal supply of money

What determines the demand formoney?

What services does money provide: medium of exchange store of value unit of account

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Why do people hold money

Transactions demand to be able to carry out normal buying and

selling

liquidity -- ability to buy and sell goodsimmediately applies to cash (notes and coins), current

accounts, and instant-access savings

As an asset applies also to non-instant access savings

accounts (time deposits)

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Cost of holding money Interest lost on less liquid assets with

higher returns -- stocks, bonds, longer-term bank deposits, etc -- is the price ofliquidity

Opportunity Cost! Cash pays a zero interest rate and

current accounts generally pay a very

tiny one. Demand for money should depend

negatively on the opportunity cost of

holding it --other things being equal

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Income, Wealth, and the

Demand for Money Transactions demand for cash depends

on how much you buy and sell High income/high spending people need

more cash / bank deposits People with more wealth may hold more

as part of their portfolio of assets(property/ stocks/bonds/pension funds/bank deposits/etc)

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Equilibrium between thesupply and demand for money

Nominal interest rate adjusts to bringsupply and demand into balance

Increase in money supply -- people findmoney holding have gone up

Peoples attempts to invest in other

assets -- bonds, stocks, etc -- pushesup bond and share prices, and reducesreturns on them

Causes lower interest rates

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Determination of rate of

interest Note that here the interest rate balances

supply and demand for money Compare with the full employment

model interest rate balances supply of and

demand for saving In the unemployment /sticky price

model, saving / investment balance

determines the level of income

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Effect of monetary policy onthe economy

Suppose the central bank raises themoney supply

Lower interest rate stimulatesinvestment

Higher investment stimulates higherincomes

Higher incomes raise the demand formoney, and cause interest rates to rise(relative to their new lower level) --

offsets part of original effect

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An increase in the money supply stimulates investment, raises theaggregate expenditure schedule, and thus shifts the aggregatedemand curve to the right

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Zero Lower Bound

2008 version of the liquidity trap Nominal interest rate cannot be lowered below zero Even then, aggregate demand may be too low Conventional monetary policy becomes ineffective Need for unconventional measures

Quantitative easing Central Bank purchases of assets from the private sector

(not only government bonds, but equities, securitisedmortgages, etc) Intervention in foreign exchange markets

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Liquidity Trap

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Monetarism Doctrine that money may have powerful

short-term effects on output, but in thelong-run only causes inflation

Economy adjusts to full employmentquite quickly -- prices not very sticky

Inflation is always and everywhere amonetary phenomenon (Milton

Friedman) The money supply affects the economy

with long and variable lags. (Milton

Friedman again)

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Quantity theory of money

demandMV = PY

with velocity fixed Identity becomes a Theory Y fixed -- economy at full employment V fixed If M goes up, then P has to go up

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Other channels of influence of

monetary policy Credit availability

banks ration credit (imperfect information /

adverse selection/ moral hazard) demand for credit at existing interest rates

is not satisfied

if more reserves are made available banksmay relax credit limits without loweringinterest rates

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Portfolio effects

Increase in money supply causespeople to attempt to invest in more

stocks and bonds. This raises share prices and bond

prices

Firms are better able to raise money onstock market and carry out newinvestment projects

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Money and Exchange Rate

Open Economy trade and capital flows

Floating Exchange Rate

exchange rate determined by capital flows asset price (relative price of two kinds of

assets)

determined largely by expected futurevalue volatile not determined by trade flows in the short

term

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Exchange Rate

Higher money supply -- lower interestrate

lower interest rate inducesfirms/households/foreign residents toinvest in other countries

capital outflow increased supply of / reduced demand

for pounds on foreign exchange market depreciation of the currency

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Current monetary policy

INDONESIA

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