KRUGMAN_WELLS_MACRO_CHAPTER14

This 14 2 the aggregate price level and money demand

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Unformatted text preview: nd curve, RMD, shown in Figure 14-3. This 14-2 The Aggregate Price Level and Money Demand Other things equal, an increase in the aggregate price level leads to an equal percent increase in the nominal quantity of money demanded. In this case, an increase in the aggregate price level causes a rightward shift in the money demand curve from MD1 to MD2. The nominal quantity of money demanded at the interest rate r1 rises from M1 to M2, an increase that is proportional to the increase in the aggregate price level. Interest rate, r A rise in the aggregate price level shifts the money demand curve rightward. r1 MD1 M1 M2 MD2 Nominal quantity of money, M UNCORRECTED Preliminary Edition Figure CHAPTER 14 M O N E TA R Y P O L I C Y 14-3 The Real Demand for Money Since money demand is proportional to the aggregate price level, money demand can also be expressed as a demand for a real quantity of money. A rise in the aggregate price level does not shift the real money demand curve. At an interest rate r1, the real quantity of money demanded when the aggregate price level is P2, M2 /P2, is the same as it is when the aggregate price level is P1, M1 /P1. Interest rate, r r1 Real money demand, RMD M1/P1 = M2/P2 curve shows the relationship between the real quantity of money demanded and the interest rate. Unlike the nominal money demand curve, the real money demand curve automatically takes into account the effect of changes in the aggregate price level on the nominal quantity of money demanded. So, for example, at an interest rate r1, the real quantity of money demanded is equal to both M1/P1 and M2/P2, shown as the same point on the real money demand curve. Shifts of the Real Money Demand Curve By expressing the demand for money in real terms, we take account of the effects of changes in the aggregate price level on the nominal demand for money. A number of factors can shift the real money demand curve. The most important of these are changes in the level of real aggregate spending, changes in banking technology, and changes in banking institutions. Changes in Real Aggregate Spending Households and firms hold money as a way to facilitate purchases of goods and services. The larger the quantity of goods and services they plan to buy, the larger the real quantity of money they will want to hold at any given interest rate. So an increase in real aggregate spending will shift the real money demand curve rightward; a fall in real aggregate spending will shift the real money demand curve leftward. Some economists have argued that the real quantity of money demanded, other things equal, is proportional to real aggregate spending. That is, a 20% rise in real aggregate spending leads to a 20% rise in the real quantity of money demanded. This view leads to a concept known as the velocity of money, which we’ll turn to shortly. Changes in Technology There was a time, not so long ago, when withdrawing cash from a bank account required a visit during the bank’s hours of operation. And since most people found themselves trying to do their banking during lunch hour, this often me...
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