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EC111LectNG14 - EC111 MACROECONOMICS Spring term 2012...

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1 EC111 MACROECONOMICS Spring term 2012 Lecturer: Jonathan Halket Week 19 The Demand for Money We can think of the demand for money as arising from three motives that are related to the functions that money performs in the economy. These are: the transactions motive, the asset motive and the precautionary motive. The last of these suggests that people hold money if they are uncertain about future income or payments and so they will wish to hold money to meet unexpected payments or income shortfalls. But our main focus is on the other two motives. Transactions demand Because receipts and payments are not perfectly synchronised, people hold money as a “buffer stock”. If I am paid £X per month and I spend continuously, my profile of money holding looks as follows: On average I am holding a money balance of £½X. We assume that money carries no interest and that transactions costs make it too expensive to continuously switch in and out of interest bearing assets. In the classical monetary theory, the stock money demand is related to transactions through the following identity: _________________ Where T is the number of transactions over the period and P is the average money amount of each transaction. The amount of money, M, necessary to support these transactions depends on the velocity of circulation, V. This is the number of times on average that each unit of money changes hands over the period. £X 1 2 3 4 5 Months
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The Quantity Theory of Money In the classical theory V is regarded as a constant, or at least to be fairly stable. In addition we can relate monetary requirements to the level of national income, Y, rather than to the number of transactions, T. Thus we have: ± ² ³´ , or: µµµµµµµµµµµµµµµµµµµµµµ The demand for real money balances, M/P, depends on real national income and the (income) velocity of circulation. The classical economists assumed that Y was fixed at full employment. So if V and Y are unchanging, any increase in M must be matched by and equal proportionate increase in P. So the Quantity Theory of Money has a simple and powerful prediction: an increase in the money supply will cause an equal proportionate increase in the price level. Asset Demand Money is a store of value but there are alternatives. We assume that the alternative asset is bonds. Money has zero interest but it is more convenient to hold and can more easily (or at lower cost) be exchanged for goods. When the interest rate is high, people will be more willing to economise on their holdings of money to obtain the interest they would get by switching some of it to bonds The interest rate represents the opportunity cost of holding money. When the interest rate is low people will prefer to hold more money and fewer bonds. This schedule is sometimes known as liquidity preference. M
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EC111LectNG14 - EC111 MACROECONOMICS Spring term 2012...

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