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Unformatted text preview: CHAPTER 4 I. Money Market and the LM curve (Liquidity Market) A. Wealth Portfolio: 1. Money - currency and checkable deposits at commercial banks and thrift institutions. a. Medium of exchange b. Store of value c. Unit of account (Dollars) d. M1= currency + transaction accts (demand deposits, other checkable deposits, Traveler’s checks) e. M2= M1+ other highly liquid assets (saving deposits, money market accts, small-denomination CDs) 2. Bonds (debt), stocks (equity), and other assets that earn a rate of return (i.e., nonmonetary financial assets) 3. Real assets: real estate, autos, etc. 4. Portfolio decisions: individuals must decide how to allocate wealth between alternative assets a. Wealth held in assets that have a rate of return → ↑ future wealth (and cons.) b. Wealth held as money → ↓ transaction costs from making purchases (i.e., cost of conversion of wealth into money which is the only asset accepted as a means of payment) 5. Note: Price of stocks and bonds move inversely with the interest rate (any nonmonetary financial asset) a. P Bond ≅ Coupon ÷ r b. P Stock ≅ [Dividend + Capital Gain] ÷ r B. Demand for Real Money Balances (M d /P) or Liquidity Preferences (L) ⇒ M d /P required to purchase a fixed quantity of goods and services 1. M d = Nominal Money Balances and P = Price Level (held constant in IS-LM) 2 2. M d /P = L is independent of P (i.e., all prices double ⇒ income and M d doubles to purchase same quantity of goods ⇒ L remains constant) 3. L depends on income (Y) and the interest rate (r) a. Amount of L depends on the opportunity cost of holding money (i.e., interest rate paid on nonmonetary financial assets). i. the higher is r , the more costly the holding of money (i.e., earnings foregone from holding money). ii. ˆ r and L are inversely related (i.e, ↓ r → ↑ L ) iii. Opportunity cost of money is the risk free interest rate which is approximated by the Federal Funds and 3 month Treasury Bill short-term interest rates. iv. Assume that interest rate responsiveness ( f ) of M d /P = ! 200 ⇒ Δ ( M d /P ) = f ( Δ r ) = ! 200 ( Δ r ) v. Graph 4-1 b. Amount of transactions for goods & services depends on the level of Y i. ↑ Y → ↑ level of transactions (note: Δ Cons = MPC ( Δ Y )) ii. ˆ in Y and L are positively related (i.e., ↑ Y → ↑ L ) iii. Income responsiveness ( h ) of M d /P = .5 ⇒ Δ ( M d /P ) = h ( Δ Y ) = .5 ( Δ Y ). iv. Graph 4-2 C. Money (liquidity) demand function: M d /P = hY ! fr = .5 Y ! 200 r D. Equilibrium in Money Market occurs a pt. where M d /P = M s /P 1. Real money supply = M s /P 2. Nominal money supply = M s ( M s is created and controlled by Federal Reserve) a. Fed’s primary asset: US Treasury Bonds and Treasury Bills....
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This note was uploaded on 04/10/2008 for the course ECON 302 taught by Professor Adamson during the Spring '08 term at SD State.
- Spring '08