PowerPoint Slides
to accompany
Prepared by Apostolos Serletis
University of Calgary
Copyright © 2010 by Nelson Education Limited
1
Chapter10
The Demand for Money
and the Price Level
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Concepts of Money
• Fiat money has value due to government fiat,
rather than through intrinsic value.
• Commodity money, such as gold and silver
coins, which do have intrinsic value.
• High-powered money, which adds the deposits
held by banks and other depository institutions.
• At the Bank of Canada, another name for highpowered money is the monetary base.
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Concepts of Money
• Monetary aggregates
– A monetary aggregate is the total dollar stock of a
group of financial assets defined to be money. The
most common definition is called M1
– Chequable deposits issued by banks and other
financial institutions.
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Concepts of Money
• Monetary aggregates
– M2 includes personal deposits and non-personal
demand and notice deposits.
– The M2 definition goes beyond the concept of money
as a medium of exchange.
– In our model, it is best to use a narrower definition of
money, for example, as currency held by the public.
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The Demand for Money
• Money is hand-to-hand currency
– Assume that the interest rate paid on money is zero.
• Bonds and ownership of capital
– Interest-bearing assets
– These assets pay a positive return to the holder.
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The Demand for Money
• The household budget constraint in nominal
terms:
PC + ∆B + P·∆K = π + wL + i · ( B+ PK)
(nominal consumption + nominal saving = nominal
income)
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The Demand for Money
• “demand for money,” Md
– The average holding of money that results from the
household’s optimal strategy for money management.
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The Demand for Money
• The Interest Rate and the Demand for Money
– A higher interest rate, i, provides a greater incentive
to hold down average holdings of money, M, in order
to raise average holdings of interest-bearing assets, B
+ PK. That is, with a higher i, households are more
willing to incur transaction costs in order to reduce M.
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The Demand for Money
• The Interest Rate and the Demand for Money
– We predict, accordingly, that an increase in i reduces
the nominal demand for money, Md.
– For a given price level, P, we can also say that a
higher i lowers the real demand for money, Md/P.
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The Demand for Money
• The Price Level and the Demand for Money
– Suppose that the price level, P, doubles. The nominal
demand for money, Md, doubles. Since Md and P
have both doubled, the ratio, Md/P, is the same.
– The result is that the real demand for money, Md/P,
does not change when P changes.
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The Demand for Money
• Real GDP and the Demand for Money
– Assume now that nominal income doubles, while the
price level, P, is unchanged.
– Households would double their nominal demand for
money, Md. Since P is constant, the real demand for
money, Md/P, also doubles.
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The Demand for Money
• Real GDP and the Demand for Money
– Economies of scale in cash management, at
higher incomes households hold less money in
proportion to their income.
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The Demand for Money
• Other Influences on the Demand for Money
– Payments technology
– The level of transaction costs
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The Demand for Money
• The Money-Demand Function
Md = P·L(Y, i)
Md/P = L(Y, i)
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The Demand for Money
• Empirical Evidence on the Demand for Money
–
–
–
–
–
–
Kevin Clinton (1973)
Norman Cameron (1979)
Stephen Poloz (1980)
Steven Goldfeld (1973, 1976)
Goldfeld and Sichel (1990) and Fair (1987)
Mishkin and Serletis (2008)
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Determination of the Price Level
• The Nominal Quantity of Money Supplied Equals
the Nominal Quantity Demanded
Md = P · L(Y, i)
Ms = Md
(Nominal quantity of money supplied = nominal
quantity of money demanded)
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Determination of the Price Level
• The Nominal Quantity of Money Supplied Equals
the Nominal Quantity Demanded
– Key equation (nominal quantity of money supplied
equals nominal quantity demanded):
Ms = P· L(Y, i)
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Determination of the Price Level
• The Nominal Quantity of Money Supplied Equals
the Nominal Quantity Demanded
– If we put the equations together, we have that the
three nominal prices—P, w, and R—adjust rapidly to
ensure that three equilibrium conditions hold
simultaneously:
• Ms = Md
• Ls = Ld
• (κK)s = (κK)d.
– This situation is referred to as one of general
equilibrium.
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Determination of the Price Level
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Determination of the Price Level
• The Nominal Quantity of Money Supplied Equals the
Nominal Quantity Demanded
– The nominal quantity of money demanded is given by Md = P ·
L(Y, i). For a given real quantity of money demanded, L(Y,i) , Md
is proportional to the price level, P.
– Therefore, the nominal quantity demanded, Md, is given by the
upward-sloping red line, which starts from the origin.
– The nominal quantity of money supplied is the constant Ms = M,
shown by the vertical blue line.
– The equilibrium condition Ms = Md holds when the price level is
P* on the vertical axis. Thus, P* is the equilibrium value of P.
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Determination of the Price Level
•
A Change in the Nominal Quantity of Money
–
–
From a one-time change in the nominal quantity of
money supplied, Ms.
The increase in Ms from M to 2M raises the
equilibrium price level from P∗ to 2P∗
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Determination of the Price Level
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Determination of the Price Level
•
A Change in the Nominal Quantity of Money
–
–
Since the technology level, A, has not changed, the
real wage rate, w/P, and labour input, L, do not
change.
Therefore, the price level, P, is twice as high, and w/P
is unchanged. We conclude that, in general
equilibrium, the nominal wage rate, w, has to double.
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Determination of the Price Level
•
A Change in the Nominal Quantity of Money
–
–
–
The unchanged technology level, A, means that the
real rental price, R/P, and the quantity of capital
services, κK, do not change.
The fixed κK corresponds to a given capital stock, K,
and an unchanged capital utilization rate, κ.
Thus, the price level, P, is twice as high, and R/P is
unchanged. We must have, in general equilibrium,
that the nominal rental price, R, doubles.
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Determination of the Price Level
•
A Change in the Nominal Quantity of Money
i = (R/P) · κ − δ(κ) .
• The doubling of Ms does not change the real rental
price, R/P, and the capital utilization rate, κ. The
rate of return on ownership of capital does not
change on the right hand side of the equation.
• The interest rate, i, is also unchanged.
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Determination of the Price Level
• A Change in the Nominal Quantity of Money
Y = A· F(κ K, L)
– A doubling of Ms does not affect the quantities of
capital services, κK, and labour, L.
– In other words, in general equilibrium, a one-time
increase in the nominal quantity of money supplied,
Ms, does not affect real GDP.
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Determination of the Price Level
• The Neutrality of Money
– In the long run, an increase or decrease in the
nominal quantity of money supplied, Ms, influences
nominal variables but not real ones.
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Determination of the Price Level
• A Change in the Demand for Money
– An improvement in the technology for making
financial transactions—perhaps increased use of
credit cards or ATM machines—decreases the real
demand for money to L(Y, i)ʹ, so that the nominal
demand becomes:
Md = P · L( Y, i)ʹ
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Determination of the Price Level
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Determination of the Price Level
• A Change in the Demand for Money
– A decrease in the real demand for money is similar to
an increase in the nominal quantity, in that the price
level, P, rises in each case.
– However, one difference is that a change in Ms is fully
neutral, whereas a change in the real demand for
money is not fully neutral.
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Determination of the Price Level
• The Cyclical Behavior of the Price Level
– A recession, in which real GDP, Y, falls.
• Decline in Y reduces the real quantity of money
demanded
• The decrease in i raises the real quantity of money
demanded
– In a recession, the real quantity of money demanded,
given by L(Y, i), decreases overall.
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Determination of the Price Level
• The Cyclical Behavior of the Price Level
– Given the nominal quantity of money supplied, Ms, the
decrease in the real quantity of money demanded,
L(Y, i), raises the price level, P.
– That is P will be countercyclical.
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Determination of the Price Level
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Determination of the Price Level
• The Cyclical Behavior of the Price Level
– In our equilibrium business cycle model, the
underlying shocks come from the supply side, not the
demand side.
– A low technology level, A—the source of a recession
in the model—means that goods and services are in
low supply.
– When looked at this way, it makes sense that P would
tend to be high in a recession.
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Determination of the Price Level
• Price-Level Targeting and Endogenous Money
– When the monetary authority seeks to attain a
specified price level, P, it typically has to adjust the
nominal quantity of money, M, in response to
changes in the nominal quantity demanded, Md.
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Determination of the Price Level
• Price-Level Targeting and Endogenous
Money
– To see how this works, we now assume that the
monetary authority wants the price level, P to
equal a target level P0. This objective is called
price-level targeting.
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Determination of the Price Level
• Price-Level Targeting and Endogenous Money
M = P · L( Y, i)
P = P0
M = P0 · L( Y, i )
nominal quantity of money =
price-level target · real quantity of money demanded
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Determination of the Price Level
• Price-Level Targeting and Endogenous Money
– Trend growth of money
• Since L(Y, i) grows at the same rate as real GDP, Y, we
conclude that M must grow at the same rate as Y.
Thereby, the growth rate of the nominal quantity of
money, M, matches the growth rate of the real quantity
demanded, L(Y, i), and allows the price level, P, to
remain constant at its target level, P0.
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Determination of the Price Level
• Price-Level Targeting and Endogenous Money
– Cyclical behavior of money
– The cyclical fluctuations in M will match the cyclical
fluctuations in the real quantity of money demanded.
– M should be procyclical.
• Empirically, the nominal quantity of money, M, is weakly
procyclical.
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Cyclical Behaviour of Money
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Determination of the Price Level
• Price-Level Targeting and Endogenous Money
– Seasonal variations in money
• The monetary authority has to vary the nominal
quantity of money, M, to match the changes in the
real quantity demanded, L(Y, i), that occur
because of economic growth or fluctuations.
• An analogous argument applies to the variations in
L(Y, i) associated with the seasons.
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