The Demand for Money and the Price Level ‘Our model has te forms of assets money, bonds and ownership of capital So fr, we have not analyzed how much money hovsehols hold ar how these holdings change overtime, We therefore tarred out our analysis in Chapters 6-9 under the assmption that exch household held a constant stock of money, Now we extend the microeconomic foundations ofthe model to eplin why & touhold hold part ofits assets as money: hat we explain the demand for meoney By demand foc money, we refer to the quantity of money that household decides to hold as function ofthe pice eel, P the teres rate, /, and other variables ‘Asmentionedin Chapter 6, we atu nthe model that mone isthe ole medium of exchange Inte economy. Houteolds exchange money fr goods onthe pods market. maney fer lbor onthe labor market money for capital services onthe etal mara, nd maney For honds onthe bond mar tet Honever households donot drecty exchange goods fo goods a process called Barter bonds for goods, and 50 on. “The money in our mode matches up with paper currency issued by a government. For Tanto the money could be US, dollar ors ised by the Federal Reserve, eo notes Cen?) the European Cenal Banik, and almost 200 oce forms of paper currency sued tthe words governments. These currencis are sometimes called at money because te hve value doe to government Bi, eatber than through intrinsic value, Tn eae fins, tices tended t rey tote on eommedty money, such 2s gold and silver coins, UM do have inti alu. These coin are valued in part for their coment of gold or ‘Jhon Is he bos Below, we discuss how another commodity, the cigarete, served seein prsoncrof-war eamp. In our model, money has no intrinsic vale iss & ‘ce of paper awed by the government. Tetefore, we do not have to consides any ‘ouces uscd up when mtinstaly valuable goods serve as money.Back To Reality TA. Radler [95 described his experience resource cost wing getter tamed of ‘th the economy’ of « German geionerof exchange Thi the ities weds money var (POW) camp during Wold Wark He couldnotsmatancounlybe mle nd wae ‘brie that clgetes became the peenry yet might deter ically over tme ‘medium of exchange, with many goods being Radford deited an atempt to inte ‘ichanged for cgrettes, which were then dice paper money ss anateratve med of ‘ted to buy other good. n addon, mast exchange. Th mney nated bythe carp prces mere cnpressedinuntsofciaeten for restaurartand wa aupposed tobe redeem ‘rampl, 5 fur crete aration of hex for afd quantity of food. However pre Ge(eform of sinh lems aos with pect t he cred of aor noted tht cigarettes hd several the pomed 0d value ofthe pape mney, atvactve haretersics as money (pf and cguetes mained the primary medium “nomogeneois reasonably duableandotcan- of eachangs For our pxposs an seresing ecient a forthe salt orn pacts fr lesson fom Rao sory that omen of ‘helagestwanactons" One drank apie. exchange knportant in any xenon, een = able aio to other conmodty moneys was the POW. camp. Money ina prisoner-of-war camp Ie we thik of money ab paper cusency issued by the government, thee are several reasons wit this money might occupy the dominant poston as an economy’: medium of xchange. Hust, the goveenment may impose lal estnions that prevent private parts, Sach 5 Microsfe Corporation, fom suing smallsz, interest bearing bonds that could Serve conveniently as hand-to-hand currency. Furtet, the government may enact statutes that reinforce the use ofits money. Asan example, there ithe praclamation thatthe U.S. olla s “legal tender forall debts public and private” The term “legal tender” mane that US. dolar currency has tobe aeceped in some forms of trade, such a payments of taxes tothe government. However, since the legaleender reguitement doce not spec the ‘rice, P, a which exchanges have to ecu the content ofthe lgal-ender provision is Lunclear—whae would legal tender meant P were infty? Perhaps more significant tht, US. courts ate more inclined to enforce contracts that are denominated in US. dollars eather than other nits “Another consideration isthe cost of establishing one's money a reliable and conve int, These cos include prevention of eounereting, replacement of worn-out notes, willingness to convert note into diferent denominations, and so on. Because ofthese costs, money would always td to bear interest ata rte Tower than bonds, In fat because ofthe inconvenieneof paying interest on hand toad currency, the interes ‘on careeney is typically zto. That fone holds $1 of currency and doesnot lose tone wilt have Sof carency in the fore. ‘We can relate our absteact concept of money to conventional messures ofthe money stock. The theoretical construct corresponds most closely to eurrency hed by the public Jn the real word, curtency held by the public difers fom tral cureney i craton, nich includes currency held inthe vals of banks and odher depository instittions, (Cucreney in ciculatio doesnot incu amounts held by the U.S. Treasury o by Federal— t k To lity marten Mach 206 the ann fan ay be exged gn or te SCCRESN Uy ve pute woe out suai aon vomacon cried ot Sere et hetntedSus four cen nwa bes Fomor o See aay ug nme, tt ermer tnt sec) pri te area ethcend e200, tncne sun thegveen open Tee icin tyseue ect Tow cemndforUs crn oe Fao is he dou enc cal high acon exec rere ee atten re he oy an pol ara Ae me a Srey rs crecy wey ete ee US Tyo aa ee Osea woracin, bees ate tat Sato be tl US. ay ce carat frllensredson 00 ma hal bod Te Siler warnthe Sng tae Caney eon aon areata be 56 Ce eee caso omer nr (eth gerne the ie a es cance hd fr enn ok te We st on en Bee promannoen ‘Sliauandeos eos oh sand Treen moans ofS. the ome Sot eps w ply ere Soce synthe form of gh enh for snl Scion ot Sea eeentTUs mene esas Red Pore sod Rath hon 00) od Soo ee chee bcnst bn of Coe othe Feel eee WMS Tron sae nd Sen 0) ‘Where is all the currency? Reserve Banks.) A further distinction is between toa currency in circulation and high powered money, which adds the deposits held by Banks and other depository istiutons Bethe Fedral Kesrve Another name for high-posfered money isthe monetary base. ' ‘hla 2006, the amount of (seasonally adjusted) cueency held by the publi the United States was $735 billion which amounted 05.6% of nominal goss domestic prod tice [ODP This amount of eutency is surpesingly large—about $2,500 per US. resident Inthe box below, we note that uch ofthe currency iin $100 bil many of which ae held abroad, eather than by US. resident. "The tex “money” offen refers toa monetary aggregate thts hronder than currency. ‘A monetary aggregate isthe total dolar tock ofa group of nancial asses defined to be shone, The must common definition, called MI, stempts to clasily ax money thease ‘Bar seeve regularly as media of exchange. This concept ad to curency held bythe pub Tithe chedlable deposits issued by banks and other Soancial institutions. Checkable de posts ae deposts eld at financial insttions that can be withdrawn by wating a check. pe smount ofthese checkable deposits (including travelers” checks) inthe United States in Mara 2006 was $649 blion, or 5.0% of nominal GDP? Therefore, Mi—the sum of‘currency and checkable deposits—was $1,384 bili, 10.6% of nominal GDP, The total MIL was 53% in curency and 47% in checkable deposit including traveler checks). In earlier times, a much smaller proportion of MI was in cucrency, and much laeger proportion was in checkable depos. Fr example, in 1960, only 19% of NL was im eurreny, whereas 81% was in checkable deposits. This change ilescrates the declining Importance of checkable deposits held at banks and other nancial institutions. These checking accounts have been replaced to a considerable extent by other forms of faancal :ssets,sach as money-marker accouns, which have become much easier to ses, “Table 1.1 shows ratios f eurtency to nominal GDP for OECD countries the rich countries inthe Organization foe Economic Cooperation and Developmeat) pls China, in 1960, 1980, and 2000, Notice thatthe ratio of curency to GDP declined! ove ime in ‘most countris—a typical ease, for France, showed a decease from 0.133 in 1960 to Table 10.1 | Ratios of Currency to Nominal GOP country 960 1900 2000 ale ‘054 ome oon ro om ours oon {lpm ono ono ose cones ons oom oom ine S = oon re 0068 oon. on find on as ons France om 00s ons Semany oon 0002 oom rece ow ono = rons on oo oon ‘aly = oo 000s bps 0009 oon om Nether ons net oo New Zand 061 0035 oo Nery one 040 oon Pocue om om 0057 South Keres 0s one oom spin ono oon oom sweden 0050 64 000 Stein om out 0m Unted ingon os 0m oon ed States o0s6 oon 008s "Note:The abe shows he at of curency held he pubic to nominal GD® The dt em Inet Moneta und Itmatrl Fran Sar,(0.052 in 1980 and 0.035 in 2000, However, ia some counties, the ratio leveled off or even rose fv 1980 #0 2000—thi patter applied to Canada, Finland, Geemany, Japan, Spi, an the United States. In 2000, the highest currency eaio was 0.121 in Japan, and the went was 0.019 in New Zealand. The United States, 30.089, was clos othe me {Ean Table 10.2 shows comparable gates wi money defined robe MI, ‘sll broader defniions of money add in other kinds of deposits held at financial ‘institutions For example, M2 ($6,777 bin inthe United States in March 2006) cludes Household holdings of savings deposi, smalLtime deposi, and retail money-market uta ands, Howeves the M2 definition goes beyond th concept of money asa medium Urexchange In our model, tis best to utes narrower definition of money, or example, as currency held bythe public Table 10.2 | Ratios of Mito Nominal GDP Gly ata ons one om ate ow? om 020 alge om. om om co 01s om om Derma on oa = Find = 080 or ms ous 0280 om ene ost one o2se tad - ow uy - ow on Jans ous 0286 nee Netbeans ome ow oe New Zand om ono ou Ne ons ous oo oral = 0390 our Southwea oot ow 0%0 Span ox one Sweden| = - = Swen’ os 0302 om ‘Unt irgdom | a = Unease oe ove ome Note: The table shows the ato of eure held bythe pb pus helale depos) Sina SO The ants rom the aera neary Fa eration Parcel Sots ‘anton ot ore unae or Sweden and he Une Kgaom‘The Demand for Money ‘We wll now extend the microeconomic foundations of ur model to consider the demand for money. Since we identify money with hand.toshand currency, we assume thatthe terest rate paid on money is zr. In contest, the rate of return on bonds and ownership ‘of capital equals the interes rate, which we assume i greater than ero, lencclorty we teferto bonds and ownership of capital a interest-bearing assets, because these nts poy {positive ret ro che holder. The importane pont that these ses yield higher fate of return than money and are therefore beter chan money as longtect store of val Nevertheless since households use moaey to make exchanges, houschols wil halé some ‘money for convenience, rather than always cashing in carn asets immediately pio ‘ach exchange, Thats the demand for money wil be reste than nero, In Chapter 6, we wrote the houschold budget constraint in nominal tems i eg tion (511) which we repeat hee (von) PC+ABYP-AK Fw t/a eR) nomial consumption + nomial evng = nominal income (On the right-hand side, the household eacives nominal prof 1 (whichis zero in ea librium, nominal wage income, wL, and nominal asset income, =(B + PK), all nthe form of money. On the lefthand side, the household uses money to buy consumption 00d inthe nominal amount PC, and to add to inete hearing assets att Se), inthe nominal smouat AB + PAK ‘Aktoug al of the income and spending terms in equation (10.1) use money it would be possible forthe household co hold litle or no money a every point in tise, Ie each inflow of income were perfectly synchronized with an equal outflow of expenditure on ‘goods oF purchases of interest-bearing ase, cach households money balance could says be close o zero, Howeres, ths syachronization would regi a great deal of fort ‘nd planning. We asian, ao genre matey, thatthe household can seduce ts over ‘money balunce by incurting more tanduetion cots. By transaction cons We tent ony expenses of time or goods elated tothe timing and frm of varios exchanges Inthe ea ‘world, examples of transaction cost are the time spent going to the banka atone teller machine (ATM), and brokerage fees (One way to maintain alow average money balance is o rush off to the store as soon 438 money wages are paid to spend one’s ene week 07 monthly paycheck on goods “Another method would be to go immediately toa financial institaton to conve all of fone’ wage income into interest-bearing asset. More realistically, 2 howsehold might immediately deposits paycheck into a bunk account or might arrange forthe paycheck to be deposed directly into an account). Ia addition, if workers were pa wages more Frequenly—say, weekly rather chan momthly-—ie would be ease for workers osointatn a lower average money balance “The scneal ideas hat, by putting more effort eto money management and, thereby, lncrsing more ransacton cos, the household can elue is average holding of mney, M. For a given cota of nominal assets, M+ 8 + PK, a eduction inthe ance level of M raises the average holding of interest-bearing asics, + PK. Since ant scones (B+ PR) the ss in B+ PK raises asset income, This, a howscholds average holding ‘of money, M, emerges from a erade-ofl. With frequent transaction strategy M wil Be Jow and asset income wil be high, but tansaction costs wil be high, Wath infequen "tansactions strategy, M wil be high and asset income wil below, but transaction owes pull e low: The household's choice of average moncy holngs entails ing the eight bulance berweenalonal ase income and added transaction cot‘ed inhow some key variables affect che quantity of money ‘The Interest Rate and the Demand for Money Mik gber households are more wiling to ince ans ‘er netial demand for mosey, NE. For a given price le ihr Towers te eal demand for money, M/. ‘The Price Level and the Demand for Money aoe onnal renal price R,ab0 double, so that the real fentl pice, R/Ps do not change. In this cass, the Man to dub te average nominal quantity of ones "To ahink about tis result suppose that a household wee: Suppose thot the inal plan for money management Int doesnot change when changes Real GDP and the Demand for Money Suppose thatthe price level, F, doubles, Assume that she nominal wage ra REST seat neice ee cry es ot 8 ‘We we the term “demand for mone,” labeled Mo deseribe the average hoiing of money chee nau from the household's opinal sag for money management: Many aa eof mony management have been developed oases his demand Foe money fea ret we donot have ogo trough these modes. Rather, we are mun ter demanded, Me Speccall, We Fa no er BE depends onthe prise level P the interest rate and real GDP, ¥ “Atighe ineres ate, i, provides greater incentive to old down average holings of ae onder to rase average holdings of interest-bearing asses, B* PK. That iy tion cost in order to reduce Fee et gsthols respond to higher by ansacing more frequently Derwent anaes earing ases, We predict, accordingly, that an increase in frees el, Py we can aso say that 2 w, and Svage rat w/ Pp and the cal owsshold nominal income, Fee eins (B + PR) on che righthand side of the budget constraint in equation (10-1), eee ah as before However, he eal value of this income, 11/P + w/P)>L + aoe unchanged Thus, we are considering a doubling of he nominal valves of are he thn changes in the rea valves. Ini eircumstancr the household would IM hel. This doubling of Mt aan seth average rel mney bslane, M/P. doesnot change Fs nominal income is $500 per 3 invhing some Frequency of SER eSttcen money and interes bearingases—dctate holding halla week's worth Sana ee crate form of mony, n this case the howsehola's average boing acer A $230. Aker the doubling of the price eel P (along wit the doubling of ' renault wage ratty ws and rental pice, R), the houschold’s nomial income Stoo ner weeks The household would noe change i feequency of exchange Berween 31000 Pet nar earings ecase the adeof for optimal money management money ane vets tamsnton cots—is the same as before, Therefore, the Bousehold aa ta weak worth of income inthe form of mone. With vice 28 much nom aaa nafs week’ worth of ncome istic as mach mone a nominal terms—$500 a3). Hone, the nominal demand for mones, MY, doubles Since M? and Pave treble, che cg, MZ/Ps isthe same. The results hat the eal demand for money, Suppose agin tha the intial plan for money managesent dictates holding half week's Se ee on average, nthe fort of money ene, when nominal income i $500, Fo isragehelling of money, M, is $250. Assume now that nominal incomedoubles to $1000, while the price level, Fis unchanged. Therefore rea income, 1/P +(w/P)-L-+i-(B/P + K}, doubles. Wits money-managerent plan were un changed, each household would sill hold half a week’ worth of nominal income as ‘money. However, haf a week's worth of income is now tice as much moey-—S500 instead of $250. Thus, hoseholds would double their nominal demand for mone), MF. Since Pis constant, the eal demand for money, Mt? also double. “This resul as vo he modified because higher el income hit the trade-off berween iret income and transaction coms. Specifically, the larger real money balance, MP, means that more eal income on as (= (B/P + K), could be gained by spending ada tional effort on money management. The key pont i that the eal teaaction cots for ‘economizing an money have not changed, Thus, when real income doubles, households fare mocvated to incur mote eransaction costo reduce thei average money holding. For ‘example, instead of holding 0.5 weeks" worth af income as money, ouscholds might ld ‘only 04 weeks" worth af iscome a money. In this ase nominal honey demand, Nes ses from $250 to $400, ater than $500. Thats, a doubling of real income raises I, But by less than 100%. The espoase of MIs in proportional em smaller than the change in seal income. (Ths results called eonomles of scale in cash management, because hishes- income households hold les money in proportion to tei income] Sine the price level, 2, ianchange the cea demand for money, Mé/P, ses, but les than proportionately, with real incon Tn the agregate, household rea income moves long wit real GDP, ¥. Tati, from (Chapter 7, the aggregate form ofthe household budget sonia is om Chak arse consumption + net investment = reo GOP deprecation realnet domestic product For sven depreciation, 8K. the ageeeste of household real income x desermined on the righthand side of equation (7-13) by real GDP, Y. We therefore have tht the aggregate real demand fr money, M!/P, rises, bu les than proportionately, with Y. Other Influences on the Demand for Money Forgiven values ofthe interest rate, the peice level , and real GDP, Y, money demand ) the real money-demand fneton. From this perspective, equation (10.2) sys nominal demand formonay = price lever demand for money) Empirical Evidence on the Demand for Money ‘Many seaisical studies have analyzed the determinants of the demand for money, Most, Of hese studies focus on MI the monetary aggregate that comprises curreney held by the Dull plus checkable depos. Howeveg some stadies have examined separately the ‘Seman for eurency "The empical results confirm negative effcts of interest rates on the demand for money, whether mone is seasured by MI or currency. For example in his classi emp Ral suis for the United Sates, Steven Goldeld (1973, 1976) found that a 10% increase ‘intrest ates (lor example, arise from 5% to 5.5%) educes the demand for Mt in the Tong ron by about 3%. Gold and Danie Sichel (1990) and Ray Fai (1987) reportedsimilar fodings for a number of OECD counties. Jack Ochs and Mark Rush (1983) showed tha he negative eet of interest ats onthe demand foc ML inthe Unite Sate rele similar proportionate effects on cutreney and checkable depos Casey Mulgan and Xavier Sal-iMartin (2000) showed tha money demand becomes sore semiive to changes in interest rates when the evel of inerese tte ick. At love ‘ates—say 2% —an increase in the ieres rate by 10% (f02.2%) lowers money demand ‘by 2%. However at an interest rate of 6%, am inerease by 10% (to 6.6% telus money demand by 5%, Thetis strong evidence for a postive effec af eeal GDP on teal money demand and weaker evidence for economies of sale inthis elation. Goldfeld (1973, 1976) found at am increase in ceal GDP by 10% lads, in the long run to an increase by about 79s in the ‘eal demand for MI. The change in MI breaks down into an increase of checkable ‘deposits by around 6% and an inceas in currency by about 10%, Therefore, coonosnes of seal inthe demand for MI apply to chickable depois but not wo curency. Our analysis predited that an increase in the price level would raise the nominal Py and the quantity of capital services, + do not change “he ixed eK corresponds ta given capital tok, K, andan unchanged capital lination rate. Thus the poe level, Ps twice as high, and R/P i unchanged. We mast haves in seneralequilbrium, thatthe aerial renal price, R, doubles Remember from Chapter 9 chat the intrest rte, jh to ual the rate of return on ownership of pital Interest rate = rat of retin on ownership of capitol es) R/P) ex He) Since the doubling of MF does not change the real retal price, R/P, and the capital ‘clization rte, x the rate of return on ownership of exptl doesnot change on the rg hand side of equation (9.8). Therefore, the ines at is also unchanged on the ete hand side of the equation, This result is important—in general equirian, with fll adjustment of the price lvl P, a onetime increase the norinal quantity of money stp Plies Mt doesnot afer the ners ate Recall that rel GDP, ¥, i ziven from the production function wed in Chapter oo Ye asFlek, th ‘The echnology level, A, is fixed, and we have shown tha doubling of M' does no affect, the quantities of capital services, cK, and labor, I. Therefore equation (9-1 implies that Ys unchanged. In other words, n general equibeium, a onetime increase inthe nom ral quantity of money supplied, MF does noe affect eal GDP. We have vend thats doubling of M' docs noc affect eal GDP, , and the interest tate, These eo variables ate che determinants of real money demand, given by LOY) in equation (10.3). This resale validates ou assumption in Figure 10.2 thatthe money demand line, M = P L(Y), does aot hfe when Mt doubles, We conelde that our pre vious resulta doubling of M leads to a doubling of the price evel, Pais cove, “To sum up, a doubling ofthe aominal quantity of money supplied, Mads to a dou bing ofall of the nominal prices—the pice level, the nominal wage eat, w; andthe nominal ental rie, R.There ae no change in real money balances, M/s the teal Wage rate e/a the real reel price, R/P- We abo conchae thatthe determinants ofthe ‘eal demand for mone, Ls emai the same—the increase in M has no eet on eal GDP, ¥, or the interest rate, Note, however, chat nominal GDP equals PY. Since P dow bles and Yi unchanged, nominal GDP dowbles, The analogous concusios hold fora decease inthe nominal quantity of money sup plied MFM halved, going fom M to M/2, P would halve, and real money balances MIP, would again be unchanged. The nominal wage rate andthe nominal rental gprice, R, would halve, so thatthe real wage rate, w/P, and the rel ental price, VP, Mould stay the same, As before, the decease in MP has ao efecto real GDP, ¥. Hence, ominal GDP, PY falls to halls inal vale. ‘The Neutrality of Money “The results inthe previous sstion exhibit a property called the neutrality of money. One ‘ie change inthe nominal quay of money supplied, affect nominal variables bur [eave real arabs unchanged Moneys neuen the sense of noc affecting zeal variables “Thea variables inte real GDF, ¥; the real wage eat, w/Ps he eel rental price, R/ Ps and the qoanityof ral money balances, MP. The interes ae also does nt change. ‘We shoud think of real variable Because tgoversiteemporasubsituion effect {or consumption and work, la Chapter 1, which induces inflation, we distinguish the minal nets ae from te real interes ate, ‘Nmost all economists acepe the nevtralty of money as valid long-run proposition “That inthe long runs an ineease or decrease inthe nominal quaniy of money sup piled, ht infigenes nominal variables bot not real ones. However, many ecoaomists ufete thar money sax accra nthe sort run, In the shor run, inereases in Mare wt tly thought increase veal GDP, Y, whereas decrease in Mare thought ro decrease ¥ ‘The min source of the difference in conclusions involves the Bexbaity of nominal Frcer_sotably the pie level, P and the nominal wage rate, w, These nominal pees are Thoughr wo be file up or down in the long run in response to increases oe decreases in IM Howeves,P and w are often viewed as less fesible in he shore un, especially when Asceeacs in MP mean that P and w have to decreas. In some moves, the assumption of ‘Doce feibty i replaced by an assumption that P fw is sticky inthe short ron. We cuss sticky peice and ck wage models in Chaper 16 ‘We mentioned thar finan innovations could affect the real demand for money. To ex- owe thee effect suppose tha the nominal demand for moneys again given nally by (002) aa ‘where [the real demand for money. As before, the nominal money demand, Mf, TParaphed versus th pice level P asthe upward-sloping ed lne in Figure 103. ‘Suppose ‘now tat an improvement in the technology for making financial teananctions—pethapsinceased us of credit eatds or ATM machines—decreaes the eal ‘demand for money # [L(Y], 50 thatthe nominal demand becomes (ey =P eo a ‘We graph the new nominal money demand, (M's the wpwadsoping green line i Figure 10.3 At any pice lve, Py she nominal quaadey of money demanded is smaller long the get line chan along the rd ie "Ge stume thatthe nominal quantity of money supplied, Mis ied at M, shown bythe veri blo linen Figue 103 Therefore the inital equilibrium pie levels P* on the versal ax. At is point, M? equal the nominal quant of money demanded, Mt ‘fer the fall in he real demand fo mone, the equilibrium pie level is PY’ on the ver- ‘alse At ths point, M' equals the new nominal quantity of money demanded, ()the Real Demand for Money a 7 4 Mae ‘The nominal dang for monty sitll geny theredin =P {9, We corr adress Inthe rea demon fr money). Teal ead lowe sang the ate penne (4) th slog there ine The orn uty of mney apple, st constant M sonny verte Useline The decrease nthe al dan for money mises the euiboum pice evel ro tal) onthe vera ‘Note thatthe decreas nthe real demand for money leads toa higher pice eel that, (Pry sabove P(A Before, we assume thatthe price level adjusts rapa soit equi. rium level) ' decreas inthe sal demand for money is sila oan inceeaein the nominal quan- tty of money supplied Mn thatthe price level, rises i each ease, Howene, one di ference is that a change ia MP is folly neutral, whereas change inthe real demand for money isnot flly neutral To see wh aot thatthe decrease inthe real demand for money ed to ass in P, while NP was fied at M. Therefore, the real quantity of mone, [M/P, decrease. In addition, th change in transactions technology tat led othe decline inthe real demand for money—such as expanded use of rei ards or ATM machines — ‘would itself have real effec. For example, che resources used up i transaction eon ‘would change. However, in most cass, the effects on macroeconomic variables, such a8 real GDF, wil be small enough to neg. ‘The Cyclical Behavior of the Price Level In Chapters 8 and 9, we used our equilibrium businescyle model stay how shifts to the technology level, , create economic fuctuations. Now we ean use out anasto the demand formoney to determine how the price evel, P, moves during economic acrsations Recal thatthe nominal demand foe money is given by (002) Wem P-t(% 1)‘k To ity Th qty tnory of mane les 103 wont na nace at poole CETTE licen wren td ttl Hee est wns sae Meapone toe bak pe el nod fet ove TSP Manone of he monet qa mony he cs rte Cate ong fom Dnid_ arqarty new peer ton et ed kang Rr? sir bre qany fore dered ee Senet tse en tran (00) eed ayo Pence nih marl qu te orton ote lnk te Tepe tpl rt pce modem gay cr Se rec socmensh sntne crams eye gar Se etre sracrfarte tytn cm eththepoption tt See armas tungsten! gay ome re gam te meil Thencrepads to pees oe trend oat tent tut caren ronal mentee er eee ames nine acon ei Hany ay he Eee Peso and seeerrn cron sed rede sal he Sr Ei ncrmcie Mover tba or hrm irs nthe rma were Tee vars tes guy of mor Ta nsove wns of So tre qany esse guy fea. cargo eager aten qn fron hve temgeey flson TE Sa ater ened nevis chiro oF | meer se stm “Think about a recession, in which real GDR, ¥ falls. The deine ia ¥ reduces the real “Juan of money demanded given by L{Y, 4) onthe right-hand side of equation (10.2) Flowever we abo found thatthe interest se, tends C0 fan a recession, The decrease Invest real quantity of money demanded, L(Y, The oveal change depends on the apres of the decteases in ¥ and, nd onthe ensiivity of LN] 1 ¥ and. Typ ‘Sat estmates indicate tat the veal quantity of money demanded, 1) declines overall {nin situations the fallin ends ro be smal, nd L(Y not very rexponsive to changes ind Therefore, we asume thats ina ecesson, the real quantity of money demanded given bby LAY dvteasesoveral, WE can ane Figure 10.3 to determine the effect ofan economic contraction on the price levels P Recall hat this gure applied to a decrease inthe eal demand for money, Tvs catned by a change in the teansacion technology. Howeves, the same construe tion apples LY) decreases for other reasons. In che present case, the ea quantity of Thome esnanded [{Y, i falls overall bocauseof the decreases in eal GDR, ¥ and the {eco ate Thus, we ea tse Figure 10.3 t0 study how the price level, P, changes ring reesion, "We se from Figute 10.3 tha, for a given aominal quantity of money supplied, the decrease inthe real quantity of money demanded, L(Y raises the price level, PClic Behavior of US, Rel GOP and th 10-4 | Price Level a Jn 5 a -04 -0s a a = we etter — oP Te ed gaph ithe devon of al GF rom ts red. The ue sah the deviation ofthe GOP unteryclcali laut nthe dection poste rea GOPand er rata el COE Hence ina recesion,a relatively igh P tends to accompany the decreas in real GDP. If we had done the analysis in teverse—to considera boom in which te eal quantity of money demanded, (, 1), ineteased—we would get the opposite eoncason. Tati he price level, , would fl. Thus, our model has 2 new prediction: if the nominal quay ‘money supplied, MP, dae noe vary, the pice lve, P, wil be slave high in eessions and relatively low in booms. That i, we predic tha P wil ecountercyial™ “Theresule hae che pric level, Picountercyccal may be counterintuitive, One might sess tat, since eeal GDP i ow in a reesion, the low rel income would lead 10 low ‘consumer demand and tend hereby, co reduce P- However, in ur equilibrium busines ‘cle model the undying shocks come from the supply side, not the demand side, For ‘example Tow technology level, A~ehe source ofa recession inthe model—means that aoods and services are in low supply. When looked at this wy, it makes sense tat P ‘Would end tobe high in «rceesin, "Now we wll consider how the mode’ predictions about the price level, Ps match up ‘wih the U.S data, We measure P by the deflator forthe gross domestic produce. We ci alate the cycheal pare of Pby using the method appli! towel GDP in Figure 8.2. Te sul isthe blue graph in Figure 10.4 This graph shows the proportionate deviation of Promins rend, We also show a the ed graph che cyclical par of eeal GDP from Figure 8.3) ‘We can see from Figure 10.4 that P rypiealydsctaates inthe direction opposite to real GDP” That sas predicted the price level is high=relative to erend—in recessions, and Jow-—telaive to trend-—in booms, The results aze sil if we use the consumer prise index (CPD ater than the GDP dlator ro measure the price eel "We see from the Bl graph in Figure 10.4 that two ofthe largest postive deviations ofthe GDP deflator from ts trend were in 1974-75 and 1981-82. These increases in he ‘price level veletd in pat the sharp ries ino pce generated by the ol are en by {he Organization of Petroleum Exporting Counttes (OPEC). These periods also feared recessions in the United States, so that real GDP was well below its rend, a8 seen on the Fed graph. Thus the pice level and real GDP moved in opposite directions athe tines of these ol shocks Howeve the inverereltion between the pice level and ral GDP isnot just he resuleo ol shocke—the pater aplis more generals to the period 1954-2006, shown in Figure 104." rare al Price-Level Targeting and Endogenous Money ‘A key assumption in our model is that the nominal quantiy of money supplied, M' i independent of the nominal demand for mosey, MP P+L[ Yi. In other words, the monary authority decides how auch nominal money, Mto prove, and sticks with his “Goanity no matter what happens to nominal money demand, MF. A formal way 0 say ‘Biss ea the money supply fonction, given nour case by MP = M, is independent ofthe ‘money demand faction. "This formulation useful for studying exogenous change inthe nominal quantity of money supplied, Mt By exogenous, we mean tha he change comes from out of the blue, frat least from outside ofthe model. The roubles that most changes in money supply ‘Steno like thin the tel worl. The head of he centeal bank does no ust wake up in fhe moening and happen to think that would be rice i the nominal quantity of money Iheee higher or lower by 10%. Usui, the changes ia MP are responses 6 economic ‘hems the changes happen Because the monetaty authority i trying to accomplish some {portant economic objective. One common objective i to achieve a desired or target ‘ale ofthe pie evel P- Related objectives, considered i ter chapeers, ate target he inflation rate sd the nominal intrest ste “When the monetary authocty seeks to attain a specie price level, Pit ypically has to adjust the nominal quantity of money in response to changes in the nominal guan- tity demandedy MH, Another way to say this shat M will be endogenous, or determined Athi the model. We therefore have setting of endogenous money. To see how this ‘works, we now agsome thatthe monetary authority wats the price level, P, to equal & Taruc lve hich we ell P. Ths objective is ale price-evel targeting or pesen purposes, we assume thatthe monetary authority can determine the path of the nominal guaatity of money, M, possibly subject to minor eandom errors. This “Shsumpion is easonable in our model basse we are aking 2 narrow view of money as Currency, However the assumption woul be less satisfactory if we tok a broader view of MM, for example, o add the deposit accounts included in broader monetary agrees, {och as MI and M2. Another reasonable asumpdion is thac the monetary authority eacontrol a monetary aggregate that is slighily Broader than currency: the monetary bass “This aggregate adds to toa earrency oustanding the reserves of final iatitations held st the central bank Since we assume thatthe monetary authority has no technical problems in controling the quantity of nominal money, the changes in M wil eet only intentional policy, not technical eos In partial, changes nM wil ccur Because the unerying objective of pricedeveltangeing,P = P, dictates changes in M. ‘We sill have equality at every point in time berween the nominal quantity of money ‘Mand the nominal quay demanded, At (006) Ma Pun Before, we thought of M as equal 1 an arbitrary quantity supplied, Mf. Now we wil et, Me endogenous—determined by equation {10.6)—and assume that the monetary Authority allows Mo adjust o achieve ts pric-leel argt (007) poe we subsite P = P from equation (10.7) into equation (10.6), we get a condition for determining the nominal quan of money: ey equation endogenous detemination of money) (008) ara) ‘Theda in equation (10.2) thatthe pron level Py canbe constant ate eget value P onlyifthe nominal uanty of money, M, aves on che left hand side to compensate for changes in the real quantity of money demanded, L{Y, i on the righthand sie. For ‘example f L(Y) doubles bus Mt stays the sine P woul have to fll satiny qua tion (10.6) Akernatives if L1Y, says the same but M doubles, P would have tore. To keep P fixed at P, proportionate changes in the real guanty of money demanded, LY), have to be matched by equal proportionate changes in M. This condition tell ws how price evel targeting determines the behavior of Min equation (108). The general point that the nominal quantity of money, M, willbe endogenous and wil react to change in varables that alfa the teal quantty of money demanded, L(Y 1} We now apply this analysis to determine Min thee setings long-term growth, eVsialfsetuations, and seasonal movements, ‘Trend growth of money To decrmine the trend in the nominal quanti of money, Mae have to allow fora long.run tend inthe eal quantity of money demanded LY, fon the sight hand side of equation (10.8) The most import source of hited is ong ‘un economic growh—that i, an upward tend in real GDR, Y. We can use the Solow {romth model from Chapter §to understand this rend, In the longus o steady-state Situation, real GDP, ¥, ows ata constant ate due to technological progress and pop lation groweh.? This growth of Y produces a coninsing se inthe eal quantity of moneydemanded, LY: I we think of money as cureeney, tbe empirical estimates of money tlemand suggest that the growth eate of L(Y} wil be abou the same as che growth rate of 72" Consider our coniton for determining the nominal quantity of money, Me (005) Ma PLD Since the price-level target, P, is constane, continuing growth of the real quantity of >money demanded L(Y, 0 the ighhand side equies Mo grow a the same rae on the left-hand sds Sine LY] grows atthe same rate as eal GDP, ¥, we conclade tha M. Inust grow atthe same rate as Y, Therchy the growth rate of the nominal quantity of money, Mr matches the growth rate ofthe real quan demanded, LY, and allows che price evel, Po remain constant a its rarget level, P “The important conclusion shat a growing economy will have growth in ts nominal quantity of money, M,asuming thatthe monetary suthoiy seeks to stabilize che rice Ieel, P. This ule accords with data considered in Chapter 1. We shall se there chat rowing M applies to almost ll counties nthe word, However, we also allow in Chap- tee 1 for inflation~that fora cntinal upward moverneat iP Cyclical behavior of money To study the cyczl behavior of money, we again use the condition for determining the wominal quantity of money, Mi (008) Ma PLD ‘We know that the real quaniy of money demanded, 1) high na boom and low in {recession his is Because a change in real GDR, Y, moves {Yn the same direction. ive assume that chi ffet dominates the impact froma change inthe interest rat) We tlso know tha f Med noe ductuate, che rice level, P, would fll ina boom and ise in {recession That P would be countereyclieal—iow zlatve to trend in booms and high felative to tend in recessions. Ifthe monetary authority wants to keep the price level , fixed a is target, P, dur ing economies Hucteations, fas to introduce a cfclcal pater into the nominal quantity fof money, M In particulary, n equation (10.8), the eplieal uctuatons in M on the lee 1 hand sid have to match the eylicalMlatuations inthe eal quanity of money demanded, IY, fom the righthand sie. Ths, Mil have oes ia boom (long with theese in {Yad fallin a recession along withthe fll in L(Y} Iv other words, M should be procyclical | cal hat we found thatthe prise level, P is countreylicl inthe US. daa. This pattern fit with our equim business-cele model when we assumed that the nomial [Guanity of money, My did no vary over the business ce In other words, the monetary ‘Tuthowty the Federal Reserve) has no pursued a monetary poiy that completly elimi ‘ated th countercylical behavior of P Mhas nor been sufienty procyclical eo avoid a ‘ounereyclical pace level Nevertheles, we would ike to now whether the monetary futhorty has fllowed a policy that is somewhat procyclical; that is, whether nominal rooney, M,is high relative to tend during Booms and low relative to wend during rece Sons ifs, this ply would have moderated the countencyclcl pater for P.Empirical the nominal quantity of money, M, is weakly procystial, For example, from 1954 2006 th coreation ofthe cysical par of currency hed bythe publ with he jell par of real GDP was only 0.08. Broader monetary aggregates are somewhat more procyclical: rom 1959 02006, the correlations wih be cjlcal part oral GDP weze 0.14 for Mi and 031 for M2. The weak procyclical pattern in monetary aggregates is consistent ‘with our nding thatthe price level, ,countercylical, The monetary aggregates would have had tobe more proyclial eliminate the counteeyccal pacer in P ‘Seasonal variations in money Wehave argued tha to achieve pric eel stably, the rmonecary authority has ovary the nominal quantity of money M, to match te changes in the real quantity demanded, L(Y, tha occur because of economic growth or focwations. [An tnalagous argument apples othe vacations in L{ Yi] esvocated wit the seaons ‘Un the mid-19805, the quantity of real currency held in December was about 2% higher than the average for he yea, whereas the amount held in Febraary was abowt 1% lower than average. Ihe monetary authority had kept the nominal quantity of curtency, M,constant ove the yas, the prc eel P, would ave ha the reverse seasonal pattern lowin December and high a Febuary. To se how the monetary authority avoided this ou ‘ome, we can again use our condition for determining the nominal quantity of money, Mi (008) Mm Petia) ‘To avoid a seasonal pattern inthe price level, P, che Federal Reserve egincered a elively high nominal quanty of eurency, My when the real quantity of money demanded, LLY, 3, was high-for example, DecemBer—and a velaiely low nominal quantity when LY, was low—for example, February. Thus, the nominal quansey of currency, M, has ‘pronounced seasonal pater, whereas the price level, P, doesnot havea sfstanl se Sonal pattern (Thats, before seasonal adjustment, Pas litle seasonal variation) "The seusonl variations inthe real demand for US. cutrency have dined sbstan tally since the mi. 1080 For example, che December eases af el currency over the tage forthe year varied between 1.6% and 22% fen 1950 to 1983, bt then fll to a9 fverage of 0.9% in the 1990s and 0.7% from 2000 to 2005. A stady by the Federal Reserve and the US. Treasury (Roaed of Governors ofthe Federal Reserve Sytem, 2003), suggests tha this change elaes to the increased use of U.S. currency infrega conti, The foreign demand for US. curreney has less of «seasonal pattern than tht found in domestic demand. Therefore the fll seasonal variation weakened when more of the tsrrency was eld hy foreigners "The pattem is diferent f we lok at checkable deposits, the her main pact of MI The seasonal variations inthe U.S el demand for checkabe deposits have noc changed so much ove ime, For example, the December exces frealchecable deposits ove the verge forthe year ranged erween 24% and 3.39% from 1959 to 1997, then ose to a9 average of 3.6% feo 1998 to 2005, The difference from currency probably ares iecause the foreign demand for US. checkable deposits is not nearly as important a he foreign demand for US. eustency. ‘Summing Up “We extended on macroeconomic model ro add another elim condition: the nom ‘nal quantity of money supplied, MP, equals the nominal quantity demanded, MY. We then fave a generabegiibium model that determines the price level, P the nominal wage rate, wand dhe nominal renal price, R. The thee nominal prices are exible and adjustrapidly to ensure thac thee equilibrium conditions hold: M = Mt, = 1 (clearing of the Tabor market, and (cK) = (eK) (cleang ofthe marker fr capital sevice) "We extended the microccanomic foundations of the model t consider the detemi- rants ofthe nominal demand for money, M =P» 1(¥,), where the fuetion L(Y) tives the quantity of money demanded in real terms, M/P. The rel guancty demanded, {{¥, iets wih eal GDR, Y, and falls with ee iterest fate, i. Shifts in financial tech nology also affect 11, “At increase inthe nominal quantity of money supplied, MT, eases nominal vat ables~such asthe price level, Ps he nominal wage rte, andthe nominal atl ece, ‘Rein te same proportion, Real variables—such as w/, R/P, and eal GDP, Yd not, Change. This property sell neutrality of money. An increas in the real uaniy of ‘money demanded, 119, i lowers P if MP is Fixed. Therefore, the model pedits that P ‘Would be counereylcal «found inthe U.S. dat, If che monetary authority seeks to keep the pric level, P, qual ro a fixed rage, P the nominal quannty of mone, M, Becomes endogenous. In particu, shifts the rea ‘quantity of money demanded, L(Y affect Min te same direction. We appli this e- Shlcin hice contexts: longterm growth, economic Huctuatons, and seasonal movement ‘ith long-term growth neal GDP, Mis predicted ro trend upward. Ina eyeial coment, hast be proche avoid counterejelical fluctuations inthe price level P, However, {empirically Mhas not been sufciently procyclical wo eiminae the countreelicl hay for of P. Ina seasonal setting, M would have ovary seasonally to avoid a seasonal pat tem in P, We found evidence fortis seasonal behavior of Key Terms and Concepts barter Mt checkale deposits Ma ommodiy money onetay agsegate demand for money ‘monetary bse Sconomics of scale in cash management ner of money Endogenous money Priclevel targeting fae money ‘quant theory of money sera equilibrium real demand fr money Fighepowered money sores of alse ire bearing ase teansaction costs legal ender Questions and Problems A, Review questions 1. What are the cous of transacting berween money and alternative financial assess) ‘You might make alist and include such ites a he time spent going to the bank or wating inline. Hl were these costs affected by the development of automatic ele ‘machines (ATMS)? 2, Consider the following changes and state whether the effec onthe real quantity of ‘money demande is increase decrease, oe no change: am increase in the nominal nerest rate, # Ban increase in el teansaction costs«am increas in eal GDP, ¥, caused bya risen per capita real GDP with population bald comseant 4 an increase in eal GDP, Y, eased by arise in population with per capita eal GDP. bald conseane am increas in the pice eel, P ‘Suppose that the nominal quantity of money, M, doubles ance an or al a. These inthe price level, , suggests that workers willbe worse off Is this coeect? Theisen the nominal wage ate, w, suggests that workers wl be beter ofthis right? «: How do your rests relate tothe concept of the neutrality of money? 4. Economists who subscribe ro the quantity theory of money believe that changes in fhe price level, Par primarily the result of changes inthe nominal quantity of money, -M. Can this conclusion be based solely on theoretical reasoning? 5. Explain why a favorable shock othe production funtion tend o reduce the price level, P Hove could the monetary authority prevent tis fallin PP 6. Explain why itis important to distinguish berwee sits in the nominal quantity of money, Mand shifts in te nominal demand for money, Me. What asociaton would wweexpece between the price lve, P and real GDP, Y, fr periods in which bosh pes ‘of monetary shifts occured? 7. Whats the meaning ofthe tem “endogenous money?" Under what circumstances ‘would endogenous money generate a posiuveasocation beween nominal money, M, and real GDR, ¥? 3. Problems for discussion 8, Effet of othe variables onthe demand for money Assume given vale of eal GDP, Ys population he nominal ntset ates el transaction costs. If thse variables ae given, would you say that he following sate ‘ments about the real demand for money are tr, false, oe uncertain? a. Asricucura societies hae lower real money demand than indus i Dictatorships have higher real money demand than democracies, ‘- Countries with Larger fraction of persons who are elderly have higher eal money demand 4, Counties wich a higher Ineacy rae have lowe real money demand. For empirical evidence on these effers, see the stady by Lawrence Kenny (1991). 9, Transaction frequency and the demand for money Suppose that a households consumption expenditure is $60,000 per year and is financed by monthly widhdeawals from a savings account, 1 Show on a graph the paren ofthe househol’s money holding over year, What is the average money balance? Should we identify this average balance withthe qua tty of money demanded in our model? b. Suppose now thar the frequency of withdrawals from the savings account css to ‘wo per month, What happens tothe average money balance? «Return to question a, But assume now that consumption expenditure i $120,000 per year withdrawals from the savings account are sill made montis what the sverage money balanee? How does this average compare tothe one in question 3.2 [si opsimal forthe frequency of withdrawals to emai the same when consump sion expenditure increases? Explain,10, Velocity of money “The yeloctyof monty is che ratio ofthe dllar volume of transactions—say, nomial GOPdivided by the nominal quantity of money: How isthe velocity of money aifeced by 4, an crease inthe nomial iterest rate? i dn increae in eal GDP, Y caused by vise in er capita real GDP with population held constant? «an incre in eal GDP, Y eased by ass in population wit pe capita ral GDP held constant? 4. aminctease inthe price level, P2 Why might nominal GDP act be the correct measure of transactions? f whac do you predict happens to the velocey ef money ab an economy develops? 11, The payments period andthe demand for money Suppose that worker has an annual income of $60,000. Assume thatthe worker eces wage payment wise per month. The worker keeps al ofthese payment in ‘ome, does not tse any alternative Gnancial asses, and pays fr consumption expen {iture of $60,000 per year fam money hong. 4 Whatis the workers average money balance? 1 What would the average money balance bef the wosker were pad monty ater than twice per month? Whit isthe general relation between the paymenss period and the demand for mosey? 44 How do the orl change if che worker pus part of his or her monthly wage payments into sivings acount ad then makes withrawals as needed fom this 12, shopping tris and the demand fe money Assume nga the conditions in he fs part of question 11, with a worker paid once fee oath, However instead of making consumption expendizare as a uniform flow The worker (or the workers spouse} makes period shopping tps. During each trip, tough goods grosses, fr example) are bough to lst onl the next ti. 1 Ifthe worker shops fous times per month, whatis the average money balance? Why isthe anowe dflerne fom that for part a. of question 112 'b, What happens ifthe worker shops only twice per month? ©. What is the general relation between the frequency of shopping trips and the demand for money? ‘Supponc thot the cost ofa shopping trip ries, perhaps Because ofan increas inthe Price of gasoline, What would bappen to the Irequency of shopping trips? What twould happen to che demand for money? 13, Transaction costs and households budget constants In our mode, we neglected the resources that households use up in transaction costs ‘oppose thas these cost ake the form of purchases of goods and services (such a fees patd wo banks or brokers), Assume that real wansaction cost decine because ofthe ex pansion of ATM machine. 2. How dos this change show up in household’ budget consrants? 1b What isthe income effec om consumption snd leisure? © Suppose that transaction cost present the ime required ro go to a hank, eather than purchse of goods and services. ethere a change in che ess For questions sand b?14, A cacency reform Suppose that the government replaces the exiting monetary uni with anew one. Foe ‘example the Unied States might shift from the old dollar to che Reagan dolla defined ‘o equal 10 old dollars, People would be able to exchange thee old currency forthe ew cureency a he ratio of 10 t0 1. Also any contact that were wten in terms of ‘old dollars are reimterpreedin Reagan dollars ae the ratio 10 01 What happens othe price level, P, and the interest ate i? 'b. What happens to real GDP, Y; consumption, Cy and labor, L? © Do the reults exhibit the neuteality of mone}? 15. Denominations of currency Consider how people divide their holdings of currency becween large bills (say, 5100 bis) versus small ones, How would the dollar faction of eurtency held in large bills depend on the following a. the pice eve, P2 by rel per capita GDP? population? incentives to avoid records of payments—for example, for tax evasion or to igus legal ecvites, such asthe drug wade? «increased holdings of U5. eurreneyin foreign countries? Given these results, the U.S. data on currency denominations ate not $0 easy to ex plain. The faction of the dollar value of eusteney ineldng coins) held in denominations (9 $100 and higher stayed near constant—between 20% and 22%-—from 1944 t0 1970. Then the fraction cose steady to reach 72% atthe end of 200. What do yu chink explains these patterns?