Chapter 9 Monetary Theory
Requirement
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1.Grasp
(1)quantity theory of money
(2)liquidity preference theory
(3)modern Quantity Theory of Money
(4)IS-LM model
(5)views of inflation＊
2.Main Point
(1)liquidity preference theory
(2)IS-LM model
3.Key Words
 Velocity
 Transaction motives
 precautionary motive
 Speculative motive
 Liquidity trap
 inflation
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Ⅰ the demand for money
1.Quantity Theory of Money
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(1)Velocity of money and equation of
exchange ----Irving Fisher
Born
Died
Nationality
Field
Alma mater
February 27, 1867
Saugerties, New York
April 29, 1947 (aged 80)
New York City, New York
United States
Mathematical economics
Yale University
Contributions Fisher equation
Equation of exchange
Price index
Debt deflation
Phillips curve
Money illusion
Fisher separation
Irving Fisher
V

P  Y
M
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P is the price level, Y is aggregate
output, Velocity V is rate of turnover
of money.
M V  P Y
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(2)quantity theory of money
M 
1
 PY
V
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Using k to represent the quantity 1/V (a constant, because V
is a constant), we can rewrite the equation as:
M
d
 k  PY
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Fisher’s quantity theory of money suggests that the demand
for money is purely a function of income, and interest rates
have no effect on the demand for money
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(3) Feature of this theory
The most important feature of this theory is that it suggests
that interest rates have no effect on the demand for money.
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(4)Cambridge approach to money demand
M
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d
 k  PY
(5)difference between Cambridge and
quantity theory of money
 Fisher’s emphasize technology factors and
rule out any possible effect of interest rates
on the demand for money in the short run,
whereas the Cambridge approach emphasize
individual choice and did not rule out the
effects of interest rates.
2.Keynes’ Liquidity
Preference Theory
(1)brief introduction
Development of the theory
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This theory is developed by John
Maynard Keynes in his 1936 famous
book the general theory of
employment, interest, and Money .
Nationality
British
Field
Political economy,
probability
Alma mater
John Maynard Keynes
(1883-1946)
King's College,
Cambridge
Contributions Macroeconomics,
Keynesian
economics,
Liquidity
preference,
Spending multiplier,
Aggregate
DemandAggregate Supply
model
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main points
There are three motives behind the
demand for money: the transactions
motive, precautionary motive and
speculative motive.
(2) Transaction motive
Refers to the demand which individual
hold money to carry out everyday
transaction.
 transactions component of demand is
proportional to incomes.
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(3) precautionary motive
Refers to the demand which people hold
money as cushion against an
unexpected need
 Demand for precautionary money is also
proportional to incomes.
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(4) Speculative motive
Refers to the demand which money is a
store of wealth.
 speculative component of money
demand is related to income and
negatively related to the level of interest
rates.
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ⅤPutting the three motives
together
demand for money equation:
L= L1 (Y)+ L2 (r)=M
+
－
 M: money supply L: money demand Y:
income r: interest rate
－ negatively related
+ positively related
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Money supply is determined by central
bank, is exogenous variable. Therefore
equilibrium interest rate is the
intersection point of the demand curve
and the supply curve.
 See chart on the blackboard
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(5) Liquidity trap
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Liquidity trap refer to a situation where
the demand for money becomes infinitely
elastic, i.e. where the demand curve is
horizontal, so that further injections of
money into the economy will not serve to
further lower interest rates.
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policy implications:if the economy enters
a liquidity trap area -- and further
increases in the money stock will fail to
further lower interest rates -- monetary
policy will be unable to stimulate the
economy.
Case study
China’s monetary policy from 1996-2002
 Please see the figure of interest rate and
investment of china from 1996-2002
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Please think about why China’s monetary
policy did not achieve the goal of
stimulating economy? Do you think
Keynes’s theory can explain this
phenomenon?
Summary of the case
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The reason of China’s monetary policy
inefficacy is as following:
1. Conduct of monetary policy is clogged.
2. Demand for money Lack elasticity.
3. social security system is
underdevelopment.
2. liqudity preference theory can not be
used in china, because our interset rate
determined by government instead of
market..
Ⅱ IS-LM Model
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Introduction of IS-LM model
 was developed by Sir John Hicks in 1937 and
is based on the analysis in John Maynard
Keynes’s influential book The General Theory
of Employment, Interest, and Money,
published in1936. The ISLM model explains
how interest rates and total output produced in
the economy (aggregate output or,
equivalently, aggregate income) are
determined, given a fixed price level.
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John Hicks
NeoKeynesian
economics
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Born:8 April 1904,Warwick, England
Died:20 May 1989
(aged 85)Blockley,England
Nationality:British
Contributions:IS-LM model
Capital theory, consumer theory,
general equilibrium theory, welfare
theory, induced innovation
Awards:Nobel Memorial Prize in
Economic Sciences (1972)
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1. aggregate demand and aggregate
supply
National income identity:
C+I+G+NE=C+S+T
I+G+NE=S+T
If do not consider export
I+G=S+T
If there is no government activity
I=S
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2. IS curve
(1)definition
The resulting relationship between
equilibrium aggregate output and
the interest rate is known as the IS
curve.
(2) Deriving of IS curve
 Please see the figure on the
blackboard
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(3)significance of IS Curve
A.The IS curve traces out the points at which the
total quantity of goods produced equals the total
quantity of goods demanded.
B. If the economy is located in the area to the
right of the IS curve, it has an excess supply of
goods.
C.If the economy is located in the area to the left
of the IS curve, it has an excess demand for
goods..
D. equilibrium in the goods market does not
produce a unique equilibrium level of aggregate
output.
3.LM curve
 (1)definition
 LM curve, which describes the
combinations of interest rates and
aggregate output for which the
quantity of money demanded equals
the quantity of money supplied.
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(2)Deriving of LM curve
 Please see the blackboard
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(3)significant of LM curve
A. The LM curve traces out the points that
satisfy the equilibrium condition that the
quantity of money demanded equals the
quantity of money supplied.
 B. If the economy is located in the area to
the left of the L M curve, there is an excess
supply of money.
 C.If the economy is located in the area to
the right of the LM curve, there is an
excess demand for money.
4.IS-LM curve
 equilibrium :equilibrium is at the
intersection of the IS and LM curves. At
this point, aggregate output equals
aggregate demand (IS ) and the quantity
of money demanded equals the quantity
of money supplied (LM ) .
 Please see the figure on the blackboard.
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Discussion:
 How can we use monetary policy to
change the equilibrium of IS-LM model
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Ⅲ Money And Inflation
1. Meaning of Inflation
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a continuing and rapid rise in the price
level .
2.views of inflation
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(1)monetarist views
 Monetarist analysis indicates that rapid
inflation must be driven by high money supply
growth.
 (2)Keynesian view
 The conclusion is the same one that the
monetarists reach: A rapidly growing money
supply will cause the price level to rise
continually at a high rate, thus generating
inflation.
3.origin of inflationary monetary policy
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(1)high employment target and inflation
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cost push inflation
demand pull inflation
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(2)budget deficit and inflation
Issue money
Monetizing the debt
――printing money
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Please analyze the reason of inflation of
China from 2010-2011.
1.expansionary monetary policy of 2009
 2.deficit
 See Excel.
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4. Activist/Nonactivist Policy Debate
(1) the response of government to high
unemployment
 (2)time lag of monetary policy
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(3)views of activist and nonactivist
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A. view of activist
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B .Views of nonactivist
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(4)expectation and the activist and
nonactivist debate
(5)rules versus discretion
 Activists： discretionary policy.
 Nonactivists :a constant-money-growthrate
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discussion
Government of china is nonactivist or
activist? why do they act as discretion
instead of monetarist rule .
Summary
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1.the quantity theory of money is a theory of
how the nominal value of aggregate income is
determined. Because it also tells us how much
money is held for a given amount of aggregate
income, it is also a theory of the demand for
money. The most important feature of this
theory is that it suggests that interest rates
have no effect on the demand for money.
Cambridge approach emphasize individual
choice and did not rule out the effects of
interest rates.
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2. liquidity preference theory thinks that there are three
motives behind the demand for money: the
transactions motives, the precautionary motives and
speculative motive. Nominal demand for money is
 L= L1 (Y)+ L2 (r)=M
 Money supply is determined by central bank, is
exogenous variable. Therefore equilibrium interest rate
is the intersection point of the demand line and the
supply line. if the economy enters a liquidity trap area - and further increases in the money stock will fail to
further lower interest rates -- monetary policy will be
unable to stimulate the economy.
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3. IS means investment equals savings,
LM means money demand equals
money supply, IS-LM model examines
an equilibrium in which aggregate output
produced equals aggregate demand,
and since it assumes a fixed price level,
real and nominal quantities are the same.
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4. A rapidly growing money supply will cause inflation.
The origin of high inflationary policy are : high
employment target which induce cost push and
demand pull inflation; persist budget deficit which
should be financed by issuing money and monetizing
debt. activists and nonactivists have a debate on
implementation of monetary policy, activists think
government should take monetary policy to stimulate
economy , but nonactivists think that economy can get
equilibrium by itself and government should increase
money supply with single rule.