KRUGMAN_WELLS_MACRO_CHAPTER14

# And the rates of return on assets that are close to

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Unformatted text preview: to money, such as Treasury bills. And the rates of return on assets that are “close to” money—fairly liquid assets like Treasury bills that are relatively good substitutes for money—move closely with the short-term interest rate. Prices and the Demand for Money Because the horizontal axis in Figure 14-1 measures the nominal quantity of money, the money demand curve shows the number of dollars demanded unadjusted for the purchasing power of a dollar. However, economists sometimes focus instead on the real quantity of money: the nominal quantity of money divided by the aggregate The real quantity of money is the nominal quantity of money divided by the aggregate price level. 346 PA R T 5 S H O R T- R U N E C O N O M I C F L U C T U AT I O N S UNCORRECTED Preliminary Edition price level. Using M for the nominal quantity of money and P for the aggregate price level, the real quantity of money is M/P. The real quantity of money, M/P, measures the purchasing power of the nominal quantity of money, M. To see why economists sometimes focus on the real quantity of money, consider the effects of a doubling of the aggregate price level on the nominal quantity of money demanded, as shown in Figure 14-2. An increase in the aggregate price level means consumers must spend more money to buy a given basket of goods and services, which translates into holding more money at any given interest rate. So a rise in the aggregate price level from P1 to P2 shifts the money demand curve rightward from MD1 to MD2. But we can be more specific about the effect of the aggregate price level on money demand: other things equal, the nominal quantity of money demanded is proportional to the aggregate price level. That is, a 50% rise in the aggregate price level leads to a 50% rise in the nominal quantity of money demanded. We can get a better intuitive understanding of this property with a little algebra. Suppose that the interest rate is constant at r1 in Figure 14-2 and that the aggregate price level rises from P1 to P2 by a factor k, so that we can express the rise in the aggregate price level as P2 = k × P1. Then the fact that nominal money demand is proportional to the aggregate price level means that the nominal quantity of money demanded after the aggregate price change (M2), and before the price change (M1) have the following relationship: M2 = k × M1. As a result, the ratio of M2 to M1 is equal to the ratio of P2 to P1: (14-1) M2 P2 = M1 P1 Equation 14-1 can be rearranged by dividing both sides by P2 and multiplying both sides by M1. This gives us the following result: (14-2) The real money demand curve shows the relationship between the real quantity of money demanded and the interest rate. Figure M2 M1 = P2 P1 Equation 14-2 tells us that the real quantity of money demanded after a change in the aggregate price level, M2/P2, other things equal, is the same as the real quantity of money demanded before the aggregate price level change, M1/P1. One way to take this result into account is to draw the real money dema...
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## This note was uploaded on 09/09/2009 for the course ECON 701 taught by Professor Charlie during the Spring '09 term at École Normale Supérieure.

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