Week 14, Day 1 - Chapter 14 Overheads (revised)

Week 14, Day 1 - Chapter 14 Overheads (revised) - Chapter...

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Chapter 14 – Monetary Policy The Demand for Money Nominal Demand Vs Real Demand Shifts in Demand for Money The Velocity Approach to Money Demand The Liquidity Preference Model on the Interest Rate Monetary Policy and the Money Market Monetary Policy and Aggregate Demand Monetary Transmission Mechanism Inflation Targeting Monetary Policy in the Long Run Money Neutrality In this chapter, we examine in more detail how monetary policy affects the economy. The Demand for Money Assets can be held in money (both in currency and deposit form). Assets can also be held in other forms including treasury bills or T-bills, which are short-term bonds and the closest asset to being money. While money (especially M1) is liquid and convenient for purchases, money yields zero or low rates of return (currency yields zero return while chequing and savings deposits have had nearly zero returns recently). On the other hand, T-bills are less liquid but have higher rates of return. Therefore, households and firms incur an opportunity cost to hold money; they give up the higher returns on T-bills. Furthermore, when interest rates (such as the overnight rate and yields on T-bills) rise, the rates of return on money do not rise as much as those on T-bills. As a result, when the interest rate is higher, the opportunity cost to hold money increases and households and firms want to hold a smaller quantity of money (ie the quantity of money demanded decreases). In other words, the money demand curve (MD) money is negatively sloped. The following graph shows the demand for the nominal quantity of money (M), the quantity of money unadjusted for inflation.
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Alternatively, we can show the real money demand curve (RMD) for the real quantity of money (M/P), the quantity of money adjusted for inflation. A change in the interest rate causes a movement along the nominal and real money demand. Shifts in Demand for Money An increase in the aggregate price level increases the nominal money demand because households need more money when prices are higher to pay for a basket of products. However, since the real money demand has already been adjusted for inflation, an increase in the aggregate price level does not affect the real money demand (ie there is no shift of RMD).
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However, both the nominal and real money demand curves will shift for the following reasons: 1) Changes in real aggregate spending (and real GDP) – In order to increase real aggregate spending, households and firms need more money to make their purchases. Therefore, an increase in real aggregate spending, which is equivalent to real GDP, increases money demand. 2) Changes in technology – Technological advances such as automated teller machines (ATMs) and the Internet make it easier for households to transfer funds from less liquid deposits (such as non-chequing savings deposits) to more liquid deposits (such as chequing deposits) and to use alternatives to money such as credit cards. Therefore, these technological changes decrease money demand.
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