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Money and R eal Economy

Money and R eal Economy. Money, Bonds, Monetary Policy, GDP. Money and Bonds There are many things in the economy Cash Chequing accounts Saving accounts Treasury bills Bonds Business shares (equity) etc Simplify Yields no interest = money Medium of exchange Cash Chequing accounts

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Money and R eal Economy

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  1. Money and Real Economy Money, Bonds, Monetary Policy, GDP

  2. Money and Bonds • There are many things in the economy • Cash • Chequing accounts • Saving accounts • Treasury bills • Bonds • Business shares (equity) • etc • Simplify • Yields no interest = money • Medium of exchange • Cash • Chequing accounts • Yields interest = bond • Medium of saving

  3. Discounting • A bond • Coupon • Maturity T • Price • Yield i • Present value of a bond • Stream of revenues in the future • Discounted future payments • Present value of a stream • In equilibrium, bonds yield market interest rate • The equilibrium market price of a bond = PV of the income stream

  4. Demand for money • Demand for money = amount of money that everyone in the economy wants to hold • Greater demand for money = lower demand for bonds • Reasons to hold money • Transaction demand • Simplest, M = aY • Precautionary demand • Speculative demand • Adjusting portfolio of financial assets • Lower interest rate expected = we expect bond prices will increase = we want more bonds now = we want to hold less money now

  5. Demand for money, curve • Interest rate is negatively related to the amount of money we want to hold • Interest rate = cost of holding money • MD = MD(i, Y, P) • ∂MD/∂I < 0 • Along the MD curve • ∂MD/∂Y > 0 • Shift in the MD curve • ∂MD/∂P > 0 • Shift in the MD curve

  6. Monetary equilibrium • Money supply MS is independent of interest rate • Print more money = greater money supply • Let banks create more money = greater money supply • Any of these increase reserves • Monetary equilibrium: MD = MS • Because the bond prices change and so the interest rate changes • This is the liquidity preference theory of interest

  7. Monetary Transmission Mechanism • Step 1: • The liquidity preference theory of interest: • Increase in MS • Decrease in equilibrium interest rate • Increase in equilibrium quantity of money • Increase in MD • Increase in equilibrium interest rate • No change in equilibrium quantity of money

  8. Monetary Transmission Mechanism • Step 2: • Decrease in equilibrium interest rate • Increase in desired investments • Demand for investments • Increase in consumption • Big ticket items • Increase in net exports • Capital outflow • Depreciation of Canadian dollar • Domestic goods cheaper than foreign goods • The slope of the AD curve

  9. Long Run vs Short Run • Short run: • Increase in money supply => • Increase in AD => • Positive AD shock • Long run • Y* = const • Recall, factor prices will adjust • Now can think: • Positive AD shock => P increases => MD increases => interest rate increases

  10. Long Run vs Short Run • We say • Money are neutral in long run • Means money do not influence real GDP in long run • Money are not neutral in short run • Means money do influence real GDP in short run • This is Classical Dichotomy

  11. Effectiveness of monetary policy • MD steep • ID flat • Monetary policy is effective • Monetarists • MD flat • IDsteep • Monetary policy is ineffective • Keynesians

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