Monetary Policy

Based on Macroeconomics by
Dornbusch and Fischer and
Elements of Economics by Tullao
Definition: Money
Is the means of
payment or
medium of
exchange
More informally, it
is whatever is
generally accepted
in exchange for
goods and services
Demand for real balances
People hold money for its purchasing
power; for the amount of goods that
they can buy with it
People are not concerned with
nominal money holdings, that is, the
peso/dollar bills they hold

Demand for Money: Theory
Real money demand is unchanged
when the price level increases, and all
real variables (i.e., interest rate,
income, real wealth) remain
unchanged
Nominal demand increases in
proportion to the increase in the price
level, given that the variables
specified above remain the same.
Demand for Real Balances:
Implications
Keynes Motives for Holding
(Demand) Money
Transactions Demand for Money
Demand for money arising from the
use of money in making regular
payments
real income T
D

interest rate T
D
transactions cost T
D

Keynes Motives for Holding
(Demand) Money
Precautionary Demand for Money
Demand for money arising to meet
unforeseen contingencies
probability of being illiquid P
D

cost of being illiquid P
D

real income P
D

interest rate P
D

Keynes Motives for Holding
(Demand) Money
Speculative Demand for Money
Demand for money that arises from
uncertainties about the money value of other
assets that an individual can hold
riskiness of returns on other assets S
D

real income S
D

interest rate S
D
Empirical Results: The Goldfeld Study
The demand for real money balances responds
negatively to the rate of interest.
The demand for money increases with the level of
income.
The short-run responsiveness of money demand to
changes in interest rates and income is considerably less
than the long-run responses.
Income (Y) i
TD
i
CP
Short-run 0.19 -0.045 -0.019
Long-run 0.68 -0.160 -0.067
Elasticities of Real M1 Money
Supply of Money: Components
Currency coins and notes in circulation
M1 Money currency + claims that can be
directly, instantly, and without restrictions
used to make payments
M2 Money M1 + claims that are not
instantly liquid
M3 Money M2 + large negotiable deposits
and repurchase agreements held primarily
by corporations and wealthy individuals
The Income Velocity of Money and
the Quantity Theory
Income velocity of money
Definition: the number of times the stock of
money is turned over per year in financing
the annual flow of income
Equal to the ratio of GDP(GNP) to the
money stock
v = Y
N
/M
S


The Quantity Theory of Money
Links the price level and the level of output
to the money stock
Expansionary Monetary Policy (EMP)
Ms C and I AD YN
open market operations
government redeems T-bills/government
bonds
reserve requirement (rr)
central bank reduces the reserve
requirement
discount rate (dr)
central bank reduces the discount rate
Contractionary Monetary Policy (CMP)
Ms C and I AD YN
open market operations
government sells T-bills/government
bonds
reserve requirement (rr)
central bank increases the reserve
requirement
discount rate (dr)
central bank increases the discount rate