Chapter 12:
The Money Market
and the AD-AS
Model
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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1
Money Market

The money market was not a feature of the
AE or AD-AS models.

Fiscal policies were financed through taxes or
by selling government bonds directly to the
public.

There was no reference to the money market.
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2
Money Market

Without the money market, we cannot
discuss inflation, interest rates, credit
availability, or exchange rate management.
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3
Functions of Money

Money is a medium of exchange.

Money is a unit of account.

Money is a store of wealth.
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4
Money As a Medium of Exchange

Money facilitates exchange by reducing the
cost of trading.

Without money, we would have to barter.

Barter – a direct exchange of goods and
services.
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5
Money As a Medium of Exchange

Money does not have to have any inherent
value to function as a medium of exchange.

All that is necessary is that everyone believes
that other people will exchange it for their
goods.
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6
Money As a Medium of Exchange

The Bank of Canada’s job is to not issue too
much or too little money.

If there is too much money, compared to the
goods and services at existing prices, the
goods and services will sell out, or the prices
will rise.
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7
Money As a Medium of Exchange

If there is too little money, compared to the
goods and services at existing prices, there
will be a shortage of money and people will
have to resort to barter, or prices will fall.
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8
Money As a Unit of Account

Money prices are actually relative prices.

A single unit of account saves our limited
memories and helps us make reasonable
decisions based on relative costs.
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9
Money As a Unit of Account

Money is a useful unit of account only as long
as its value relative to other prices does not
change too quickly.

In a hyperinflation, all prices rise so much
that our frame of reference is lost and money
loses its usefulness as a unit of account.
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10
Money as a Store of Wealth

Money is a financial asset.

As long as money is serving as a medium of
exchange, it automatically also serves as a
store of wealth.
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11
Money as a Store of Value

Money’s usefulness as a store of wealth also
depends upon how well it maintains its value.

Hyperinflations destroy money’s usefulness
as a store of value.
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12
Money as a Store of Wealth

Our ability to spend money for goods makes
it worthwhile to hold money even though it
does not pay interest.
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13
Demand for Money

The demand for money is how much money
people wish to hold as cash.

The money supply is determined by the Bank
of Canada.

The interest rate results from the interaction
of money demand and money supply.
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14
Quantity Theory of Money

Every transaction must have a buyer and a
seller.

Aggregate purchases equal aggregate sales.
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15
Quantity Theory of Money

Total sales equal the number of transactions
(T) times the average price per transaction
(P).

Total sales equals the amount of money in
the economy (M) times the average number
of times it changes hands (V).

Since all transactions are assumed to be paid for
by money.
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16
Quantity Theory of Money

The equation of exchange is an identity:
MV ≡ PT

V is the transaction velocity of money -the average number of times that a dollar is
exchanged between a buyer and a seller in
one year.
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17
Quantity Theory of Money

V is assumed constant

P is measured by the consumer price index.

M is measured as M1, or other measure of
the money stock.
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18
Measuring Transactions

T is more difficult to quantify.

The volume of transactions moves in a stable
proportion to people’s nominal income, P*Y,
so the demand for money is proportional to Y.
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19
Measuring Transactions

We can write the demand for money as
Md = kPY


The k translates the economy’s nominal
income (PY) into nominal money demand.
The k became known as the Cambridge k.
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20
Quantity Theory of Money

The Cambridge k turns the equation of
exchange into a theory of money.

The income velocity of money is the
average number of times a dollar is
exchanged to generate the observed level of
nominal income,
V = PY ÷ M
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21
Income Velocity

Income velocity of money is relatively stable,
but has changed due to:

Financial innovations



automated teller machines
new types of bank accounts
Interest rates


As interest rates rise, we hold our wealth and
income in assets which pay interest.
Money does not pay interest.
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22
Keynesian Approach to Money
Demand

Keynes believed there were three motives for
people to hold money:

Transactions demand

Precautionary demand

Speculative demand
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23
Transactions Demand for Money

The transactions demand for money is
money that is needed to undertake
purchases of goods and services.

It increases with increases in income.

It decreases with frequency of payment
periods.
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24
Precautionary Demand

The precautionary demand for money is
money that is needed to meet unforeseen
expenses.

People hold an amount of money over and
above what is necessary to meet normal
expenses.
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25
Speculative Demand

The speculative demand for money is
money that forms part of an individual’s
portfolio of assets.

Keynes considered a portfolio to be
composed of two types of assets, money and
bonds.
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26
Speculative Demand

Money does not pay interest when held
outside of a bank, but money increases in
value when the price level falls.

Bonds pay interest and may generate a
capital gain when sold.
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27
Secondary Financial Markets

Secondary financial markets encourage
people to own financial assets by providing
liquidity.

Liquidity – the ability to turn an asset into
cash quickly.
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28
Bond Yield

When a bond matures, the holder is paid the
face value of the bond.

The difference between the face value and
the purchase price of the bond is the yield.

It is calculated as a percentage.
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29
Bond Maturity

Maturity refers to the date the issuer must
pay back the money that was borrowed plus
any remaining interest, as agreed when the
asset was issued.
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30
Liquidity Preference

The profit from holding a bond is greater than
the profit from holding money, yet people still
hold money for liquidity purposes.

Liquidity preference is the choice between
holding bonds or money.
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31
Liquidity Preference

Keynes believed individuals formed a
“normal” rate of interest, the rate they
believe rates will return to in normal
conditions.

Everyone has a different value for the normal
rate of interest.
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32
Liquidity Preference

Keynes believed that people’s expectations
regarding interest rates affected their liquidity
preference.

Above the normal rate of interest, people will
choose to invest all of their portfolio in bonds.

Below that rate, people will hold only money.
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33
Liquidity Preference

Money demand is zero above the normal rate
of interest.

As interest rates fall to normal, bond prices
rise, resulting in a capital gain.

Bond prices and interest rates are inversely
related.
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34
Liquidity Preference

The money demand curve is a smooth
downward-sloping function because
everyone has different beliefs about what the
normal rate of interest should be.

There is a negative relationship between the
interest rate and money demanded.
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35
Demand for Money

The demand for money combines the
transactions demand, precautionary demand,
and the speculative demand for money.
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36
Demand for Money

Money demand is a positive function of the
price level and real income.

It is a negative function of the interest rate.
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37
Demand for Money

Money demand is written as
Md = P(Md0 + hY – li)

Md0 is autonomous money demand.


It is the amount of money held if income is zero.
People may have accumulated savings, they may
borrow, or may receive transfer payments.
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38
Demand for Money
Md = P(Md0 + hY – li)

h is the sensitivity of money demand to
changes in real income

l is the sensitivity of money demand to
changes in interest rates
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39
Money Market Equilibrium

To find equilibrium in the money market, we
set money supply equal to money demand,
Md = Ms

This yields the equilibrium interest rate.
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40
Money Market Equilibrium

The interest rate is the opportunity cost of
holding money, since the money could be
placed in an interest-earning asset.

Money earns no interest.
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41
Slope of the Money Demand Curve

The larger the value of l, the more sensitive
money demand is to the interest rate, and the
flatter the money demand curve.

An increase in interest rates will cause
people to move their money holdings into
interest-earning deposits.
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42
Shift of the Money Demand Curve

The money demand curve will shift when real
income or autonomous money demand
changes.

It will shift right when real income rises.

It will shift right if autonomous money
demand rises.
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43
Shift of the Money Demand Curve

Given a fixed money supply, an increase in
money demand will cause equilibrium interest
rate to rise.

A shortage of money causes its price to rise.

The price of money is the interest rate.
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44
From Money Market to AD-AS

The AD curve gives combinations of the price
level and real income where the goods
market and the money market are both in
equilibrium.

It has a negative slope.
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45
From Money Market to AD-AS
Interest rate
Interest rate
Ms/P1
Ms/P0
Investment Demand
i1
i0
MD/P
Money demand
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I1
I0
Real Investment
46
From Money Market to AD-AS

If the price level rises from P0 to P1, real
money supply will decrease.

The existing money supply has lost
purchasing power.

The money supply curve shifts left.
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47
From Money Market to AD-AS

At the existing interest rate, i0, there is an
excess demand for money.

To achieve equilibrium in the money market,
the interest rate must rise.

At an interest rate of i1, the money market
once again is in equilibrium.
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48
From Money Market to AD-AS

As the interest rate rises, it affects the goods
market.

As the interest rate rises, investment projects
are not undertaken where the rate of return is
less than the higher interest rate.

Investment demand falls.
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49
From Money Market to AD-AS

Lower Investment spending lowers
equilibrium real income through the multiplier
process.

This results in a negative relationship
between the price level and real income.
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50
Slope of the AD Curve

The AD curve will be flatter:

the steeper the money demand curve.

l is small

the flatter the Investment demand curve.

the greater the investment multiplier.
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51
Slope of the AD Curve

The AD curve will be steeper,

the flatter the money demand curve.

l is large

the steeper the Investment demand curve.

the smaller the investment multiplier.
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52
Money Neutrality

In the Keynesian approach, changes in the
money market are transmitted to the AD
curve through the interest rate affecting
Investment spending.

Classical economists don’t share this view.
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53
Money Neutrality

The quantity theory suggests that if real
income and velocity are constant, then
changes in the money supply will only affect
the price level.

If money supply were to double, the price
level would also double.
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54
Money Neutrality

This result is known as money neutrality –
changes in the money supply will change
only the price level by the same proportion.

All real variables will be unaffected.

For example, investment spending, consumption
spending, and unemployment.
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55
Money Neutrality
(Patinkin’s) famous helicopter:

If a helicopter were to drop enough cash that
everyone’s money holdings doubled, the
result would be a doubling of prices.
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56
Money Neutrality

The real money demand function is a
demand for purchasing power.

In the long run, real purchasing power is
determined by real variables.

Not by the nominal money supply.

Not by pieces of paper.
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57
Statistical Evidence of the Keynesian
Money Demand Function

Since money supply equals money demand
in equilibrium, economists measure money
demand using the money supply figures.

If the money market is not in equilibrium,
market forces will return the money market to
equilibrium very quickly.
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58
Statistical Evidence of the Keynesian
Money Demand Function

There is a positive relationship between the
Canadian money supply and the consumer
price index.

The relationship is close to one, which
suggest that money neutrality holds for
Canada.
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59
Money Demand Relative to CPI
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60
Statistical Evidence of the Keynesian
Money Demand Function

There is a positive relationship between the
Canadian money supply and real GDP.

The relationship provides support for the
Keynesian money demand function
developed in the chapter.
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61
Money Demand Relative to Real GDP
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62
Statistical Evidence of the Keynesian
Money Demand Function

The relationship between the Canadian
money supply and interest rates is not clear.

There does not seem to be a relationship
between money demand and interest rates.
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63
Money Demand Relative to Interest
Rates
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64
Statistical Evidence of the Keynesian
Money Demand Function

This suggests that the value of l is very close
to zero.

If so, the money demand function is very
steep.
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65
Statistical Evidence of the Keynesian
Money Demand Function

Money demand is not sensitive at all to
changes in interest rates.

This may be due to the various financial
innovations in the 1980s and 1990s.
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66
Statistical Evidence of the Keynesian
Money Demand Function

If money demand is not sensitive at all to
changes in interest rates, then changes in
money supply will have a large impact on
interest rates.

Large changes in interest rates will have a
large impact on investment spending.
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67
Statistical Evidence of the Keynesian
Money Demand Function

In this case, monetary policy – changing the
money supply – will be a very powerful tool
for changing real income.
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68
The Money Market and the
AD-AS Model
End of Chapter 12
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69