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Chapter 15

Chapter 15 - Liquidity Preference Theory Determine the...

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Liquidity Preference Theory Determine the market interest rate in the short run To develop the LP Theory, consider the supply and demand for money and how they depend on the interest rate. LP Theory – a model of demand and supply of money balances in the short run. In the long run, - Real Interest rate balances the supply and demand for loanable funds . - Price level balances the supply and demand for money . In the short run, according to Keynes, - Liquidity Preference Theory says market interest rates balance the supply and demand for money . Is the market interest rate the real interest rate or the nominal interest rate? (Ans: Both are -> might be on exam ;/) Recall : The Fisher Equation Nominal IR = Real IR + Inflation In the short run, when we assume prices are fixed or “sticky”, then there is no change in inflation, i.e. Δinflation = 0. Therefore: Δnominal IR = Δreal IR Controlling the Money Supply 1. Open market operations Where the Bank of Canada: Sells bonds/securities to money supply. Buys bonds/securities to money supply. 2. Changing the bank rate Where the Bank of Canada: Decreases the bank rate to money supply. Increases the bank rate to money supply. Since money is the most liquid asset, money is demanded for its convenience, i.e. money demand is the demand for liquidity. (Look up slide 7-8) The Demand for Money ↑IR -> ↑opportunity cost of holding money -> ↓Q m d ↓IR -> ↓opportunity cost of holding money -> ↑Q m d There is an inverse relationship between the IR and Q m d which implies a downward- sloping demand for money curve.

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Shifts in the Demand for Money Curve Recall, we use money to buy goods and services. Nominal GDP = ∑P x Q If either price or quantity increases , the dollar value of transactions will increase and the demand for money curve will shift to the right. For a given interest rate , if the dollar value of transactions increases because of: i) An increase in prices , OR ii) An increases in output (quantity) Then the demand for money curve shifts to the right. Note: The opposite is true. If the dollar value of transactions decreases because of i) Decrease in prices, OR ii) Decrease in output (quantity) Then the demand for money curve shifts to the left. (Look up slide 10 ) Money demand - The demand for the liquidity of cash balances - Inversely related to the interest rate Money Supply - Controlled precisely by the Bank of Canada (assumption). - Does not depend on the interest rate. Note - Changes in the interest rate are movements along the money demand curve. - Changes in the price level OR changes in real output will shift the money demand curve.
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