ECO 100Y

Introduction to
Economics
Topic 16: The Impact of Money
Source: LR12, LR11, Chapter 28; Chapter 29 to pg 705, skim the
rest; LR10, Chapter 27; skim rest of Chapter 28.
References to open economy and exchange rates
will come later; focus on short run only.
 

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The Money Market

 There is a market for money:
 With a Demand curve
 With a Supply curve
 With an equilibrium Price
 Special features:
 Demand = L = Liquidity Preference
 Demand is negatively-sloped (explanation soon!)
 Supply = M = Money Supply (M1)
 M1 is fixed, until altered by monetary policy
 Price = r = Rate of Interest

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The Bond Market
 In the Simple Model, households can hold wealth in 2
forms:
 Money (which provides no interest return)
 (Government) Bonds (which do provide a return)
 Bonds have a price, as determined in the “bond
market”
 The rate of interest and the bond price are inversely related
 As the supply of bonds increases, the bond price will fall and
vice versa

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Diagram of the Money Market

M
r

r*

Quantity of Money
L, M

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Equilibriating Process
in the Money Market
 If r1 > r*, then L1<M
M  Excess supply of money
r
 Increases demand for bonds
 Bond price rises; r falls
r1
r*  If r2 < r*, then L2>M
r2 L  Excess demand for money
 Increases supply of bonds
L1 L2 L, M  Bond price falls; r rises

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The Demand For Money

 There are 3 drivers:
 Rate of Interest (opportunity cost)
 ∆L /∆r < 0

 Level of real GDP (size of the economy)

 ∆L /∆Y > 0

 Price level (inflation)

 ∆L /∆P > 0

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The Demand For Money
(Constant-Price Keynesian Model)
 Keynes provided 3 explanations:
 Transactions Demand (to facilitate transactions)
 ∆Lp /∆Y > 0

 Precautionary Demand (extra, “just in case”)

 ∆Lt /∆Y > 0

 Speculative Demand (hold money as an asset)

 ∆Ls /∆r < 0

 L = Lt + Lp + Ls
 L = L(Y, r)

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The Effect of An Increase in M1

(in the Money Market)
 An increase in the
Money Supply:
r M1 M2
 Shifts M to the right
 Causes r to fall r1
r2
L

L, M

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The Demand for Investment Goods
 So far, the Investment Demand schedule has been:
 I = Constant
 I = Constant + MPI*Y
 Now we recognize that the rate of interest drives I
 A lower r reduces the cost of borrowing for capital projects
 A lower r reduces the opportunity cost of using retained
earnings for capital projects
 ∆I /∆r < 0
 The I schedule (Marginal Efficiency of Investment) is
negatively-sloped (with respect to r)

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A Lower Interest Rate Affects

Investment Demand
 A lower rate of interest:
 Encourages greater r
desired Investment
Spending
r1
 Movement down the I
schedule r2
 Also, may encourage I
consumers to spend more
(not part of our simple
model) I1 I2 I

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Higher Desired I Affects
Aggregate Expenditure
 As business desired Y = AE
investment spending AE2
increases: AE

 AE shifts up AE1

 GDP increases (if Y1 <YF)

 A change in the Money
Market has caused a change
in the Goods/Output Y1 Y2 Y
Market!
 Note also that AD shifts to the AE has shifted up by ∆I
right (but no change in the price
level in the constant-price model) GDP increases by KI *∆I

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Summary of Monetary Transmission

Mechanism
 How does a change in M affect the real economy?
 Money Supply increases  r falls
 Lower r  Desired I spending increases
 Higher Desired I spending  AE shifts up
 Higher AE Schedule  Y increases
 BUT, there is a (smaller) second-order “Feedback Effect”
 As Y increases, so does the Demand for Money (L)
 This causes L curve to rise in the Money Market
 r does not fall as much, I demand does not rise as much
 AE and Y do not rise as much

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The Effectiveness of
Monetary Policy
 For a given change in the Money Supply, by how much
will GDP change?
 If a large change  very effective
 If a small change  relatively ineffective
 If no change  totally ineffective
 Demonstrate that effectiveness is
determined by 2 factors (Ignore the “feedback
effect”):
1. Interest elasticity of L curve
2.Interest elasticity of I curve

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Fiscal Policy and “Crowding Out”

 Two Problems:
1. Show that an increase in government spending
(financed by the sale of new bonds to the public)
will lead to a higher interest rate, thereby
"crowding out" some investment spending, and
lowering the value of the KG as computed in the
simple Keynesian model presented earlier. (Ignore
the “feedback effect”).
2. What kind of "accommodating" monetary policy is
necessary if the crowding out effect is to be
avoided?

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