Thursday, November 01, 2007

Topic 8 (Chapter 17)

I) Demand for Money
a) Money balances - people have a desire to hold money
i) transactions demand - for purchases
ii) precautionary demand - for unexpected expenses (like if your car's transmission dies)
iii) asset demand - holding money compared to holding stocks and bonds

b) asset demand - why hold money rather than assets
1) advantages - liquidity and no risk
2) disadvantages - you don't earn any interest or gains in asset prices

c) Demand for money, therefore, should be inversely related to asset prices. For simplicity, we will assume the only asset price is the nominal interest rate. The higher the interest rate, the lower the demand for money (asset demand for money).

II) Tools of Monetary Policy
a) Liquidity preference graph - top of page 426 (the book doesn't mention its name)
b) Money demand (described above) and Money supply (fixed by the fed
c) Tools of the central bank
1) Fed Funds rate - the most used. It is the rate banks charge eachother to borrow reserves. Sale of bonds by Fed (more money supply, lower interest rate). Fed buy's bonds (takes money out, money supply contracts, interest rates rise).
2) Discount rate - the rate the Fed charges to borrow reserves.
3) reserve requirement.

III) Effect of monetary policy on output - use aggregate demand and supply

IV) Monetary policy transmission mechanism
a) Page 435
b) The argument is that lower interest stimulate the economy through higher investment. But it also stimulates the economy through higher consumption
c) However, this is only a short run argument. In the long run expansionary monetary policy can only result in higher inflation.

V) Putting together fiscal and monetary policy with a realistic AD/AS curve
a) aggregate demand - still the same
b) long run aggregate supply - still the same
c) short run aggregate supply - upward sloping now (this is a partial concession to Keyne's. An upward sloping curve means prices rise, but in the short term the market does not fully adjust to the fiscal or monetary expansion.

VI) MV=PY and its relation to the long run
a) definitions
1) M = Money
2) V = Velocity
3) P = Prices
4) Y = output

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