Money and Real Economy
Money, Bonds, Monetary Policy, GDP
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 Money and Bonds
 There are many things in the economy
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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
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 Discounting
 A bond
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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
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 Demand for money
 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 = aY
 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
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 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
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 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
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 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
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 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
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 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
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 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
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 Effectiveness of monetary policy
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MD steep
ID flat
Monetary policy is effective
Monetarists
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MD flat
ID steep
Monetary policy is ineffective
Keynesians
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