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Chapter4_302 - CHAPTER 4 I Money Market and the LM...

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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)
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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. b. Fed’s primary liabilities: Currency and Bank Reserve Accounts (on deposit with the Fed) = monetary base. c. Assume that the average required reserve ratio ( rr ) on all deposits is 20% money multiplier = 1/ rr = 1/.2 = 5.
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3 d. M s /P = 1/ rr H (monetary base) = 1/.2 H 400 = 2000.
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