Monetary Theory - Monetary Theory ECON 3381:Spring 2010 A....

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Monetary Theory ECON 3381:Spring 2010 A. Hales
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Monetary Theory Study of the effect of money on the economy. A core issue in monetary theory is the behavior of money demand—specifically whether and to what extent the quantity demanded of money is affected by changes in interest rates.
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The Equation of Exchange Where: M=the money supply V= the velocity of money ( the number of times money changes hands) P=the aggregate price level Y=output in the economy This is an identity; it is true by construction. In order to develop it into a theory we need some information on the behavior of these macroeconomic variables. Y P V M * *
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Keep in mind… Fiscal policy : actions taken by the government (through spending or taxes) to influence the macroeconomy. Monetary policy : actions taken by the Fed (through the money supply) to influence the macroeconomy
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Classical Theory A classical economist believes that the economy is self- regulating and is always at full employment Classical theory was developed by economists like Adam Smith, David Ricardo, and John Stuart Mill.
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Classical Theory Fiscal Policy Recommendation: Minimize government intervention in the economy because taxes and government spending stunt incentives and create inefficiencies. Monetary Policy Recommendation: Back to the equation of exchange
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Classical Model- Money and the Macroeconomy Classical economists believe that the institutional and technological features of the economy affect the velocity of money only slowly so velocity is constant in the short-run. This becomes the quantity theory of money. Y P V M * *
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Classical Model- Money and the Macroeconomy However, also remember that the economy always operates at full employment so that aggregate output is constant. This implies that an increase in the money supply will be followed by a proportional increase in aggregate prices. Therefore, expansionary monetary policy leads to inflation. Monetary Policy Recommendation: Let the economy self-regulate. Monetary policy intervention only leads to inflation but has no impact on economic growth. Y P V M * *
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Classical Model- Money Demand The quantity theory of money also tells how much money is held for a given level of income—theory of the demand for money. Remember that in equilibrium, money supplied should equal money demanded. Therefore we have. Y P V M d * * =
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Money Demand Solving for Md yields: This says that the demand for money is determined by nominal income (specifically the price level because real income is fixed). There is no role for interest rates in the determination of money demand. The idea is that people only hold money for conducting transactions. Y
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Monetary Theory - Monetary Theory ECON 3381:Spring 2010 A....

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