Module 28/31- The Money Market
and the Equation of Exchange
J.A.SACCO
Graphing Monetary Policy
 Three types of “Money
Demand”
1. Transaction Demand- hold
money as a medium of
exchange. National income
increase, the demand for
money increases
2. Precautionary Demandunplanned emergencies
3. Asset Demand- Money as a
store of value instead of
other assets.
Graphing Monetary Policy
 Demand for Money Curve
Why downward sloping?
• At high interest rate MD is low because rather hold
other assets -opportunity host of holding money is
high (give up interest on other assets)
• At low interest rate, MD is high because rate of
interest on holding other assets is low -opportunity
cost of holding money is low
Int. rate
Int. rate
/ Q.D. of Money
/Q.D. Money
*Remember a change in the interest rate is only a movement
up and down the Money demand curve
Graphing Monetary Policy
 Demand for Money Curve
Shifts?
 Changes in price level
PL increase/ MD increase
PL decrease/MD decrease
 Changes in Real GDP
GDP increase/ MD increase
GDP decrease/ MD decrease
 Changes in technology- ATM’s, credit cards
Tech. increase/ MD decrease
Tech. decrease/ MD increase
*Remember a change in the money
demand curve is a shift of the curve
Graphing Monetary Policy
 Money Supply
Curve
 Always vertical, stock
concept
 MS increase, IR decrease,
expansionary
 MS decrease, IR increase,
contractionary
Key Point- Interest rate in the money market is
determined by the price of bonds in the bond market
Expansionary Monetary Policy
 Fed. Buys Bonds
1.
2.
3.
4.
5.
6.
7.
Price of Bonds?
Money Supply?
Interest Rate?
Invest? Consump?
GDP?
Inflation?
Unemployment?
Draw an AD/AS model starting with
a recessionary gap and show the
results of the monetary expansion.
Expansionary Monetary Policy
 Fed. Buys Bonds
1.
2.
3.
4.
5.
6.
7.
Price of Bonds?
Money Supply?
Interest Rate?
Investment/Consumption?
GDP?
Inflation?
Unemployment?
Contractionary Monetary Policy
 Fed. Sells Bonds
1.
2.
3.
4.
5.
6.
7.
Price of Bonds?
Money Supply?
Interest Rate?
Invest? Consump?
GDP?
Inflation?
Unemployment?
Draw an AD/AS model starting
with a expansionary gap and show
the results of the monetary
contraction.
Contractionary Monetary Policy
 Fed Sells Bonds
1.
2.
3.
4.
5.
6.
7.
Price of Bonds?
Money Supply?
Interest rate?
Invest/Consumption?
GDP?
Inflation?
Unemployment?
The Equation of Exchange
 Mathematical expression of the “quantity theory of money” devised
by Irving Fisher
Aggregate amount
spent by buyers
=
Total value of all
goods and services
MV=PQ
• Equation to explain how exchange and the role
of “M” and “V” in determining the level of output (P &Q)
The Equation of Exchange
M = Stock of Money- M1 money supply. Currency, travelers
checks, checkable deposits.
 V = Velocity of Money-Income (GDP) velocity of circulation.
The average number of times a dollar is spent on final goods and
services per time (usually a year).
The Equation of Exchange
P = The average price of the final goods and services in GDP.
The GDP Deflator.
Q = Real Output. The quantity of goods and services in
GDP. Real GDP in dollars of the base year of the deflator.
The Equation of Exchange
 Example-
1.
M= $300B and V= 5, therefore if Q = $750B then P = ?
$2 per unit
Why is this equation important to the money supply?
• Provides insight into what would happen to
output(Q) and prices (P) when money supply changes.
The Equation of Exchange
 Assume Velocity of Money (V) is constant.
 If the Supply of Money (M) increases, then either Price (P) or
Output (Q) or both must increase. The effect of the change
in M on P and Q will depend on the state of the economy.
Crude Quantity Theory of Money and Prices
 If the economy is operating well below full employment
(recession), an increase in M will tend to raise Q (ouput)
more than P (price) as unemployed resources are reemployed.
 If the economy is already at full employment or above, any
increase in M will tend to raise P more than Q. The increase
in M will be purely inflationary.
 Thus the state of the economy will have a major impact on
whether or not to increase the money supply.
Crude Quantity Theory of Money and Prices
 So if GDP (Q) can increase 3-5% a year.
 Then if Q does increase by 3-5% a year, any increase in M
above 5% merely increases the price level (demand pull
inflation )
 Increases of less than 3% in M means Q cannot increase by
3% so the price level will fall, recession.
 The key is to grow the money supply with the growth of
output (real GDP) in order to maintain economic stability.