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1° Part (Macroeconomics) 2° Part (Central Banking) 3° Part (Optimum Currency Area)
1° Part (Macroeconomics) 2° Part (Central Banking) 3° Part (Optimum Currency Area)
Keynesian theory
According to Keynes’s theory of the demand of money, which he called the liquidity preference theory, he
postulated that there are three motives behind the demand for money: the transactions motive [current
consumption], the precautionary motive [future consumption] and the speculative motive [store of value].
Money demand with a transaction and precautionary motive is MD = f(Y). Money demand with a speculative
motive is MD = f(i), the speculation revolves around the difference between the current and the expected interest
rate. Notation:
MD = Demand for money (nominal), MS = Money supply (nominal), P = price level, Y = real output (while Yn =
nominal output), i = nominal interest rate, r = real interest rate, Pe = expected inflation.
Features of MD with a speculative
motive:
Money has maximum liquidity
Bonds is the only alternative
Bonds have inverse relation
between interest rate (i) and price
(PT)
Current interest rate (i)
matters not the
e
expected rate (i )
In the Keynes’ analysis an
individual holds his wealth
in either all money or all
bonds depending upon his
estimate of the future rate of interest.
The portfolio approach to demand of money put forward by Tobin, Baumol and Friedman is a response to the
limits to Keynes’ theory:
The gap between current level of the interest rate and expected rate (normal level) tends to disappear in
the long-run
Speculative motive is secondary to the transaction motive, implying low interest rate elasticity of money
demand, while the modern theories of money demand show that money held for transaction purposes is
interest elastic
The public, unrealistically holds either money or bonds, for Keynes, while it is possible a combination of
both
James Tobin explained, in his Portfolio Approach to demand for money, that rational behavior on the part of the
individuals is that they should keep a portfolio of assets which consists of both bonds and money, so the problem
is what proportion of portfolio to keep in the form of money and what in interest-bearing bonds. According to
Tobin, individual’s behavior shows risk aversion, they prefer less risk to more risk at a given rate of return and are
uncertain about future rate of interest.
Baumol concentrated on transactions demand for money from the viewpoint of the inventory control or inventory
management similar to the inventory management of goods, asserting that individuals hold inventory of money
because this facilitate transactions (i.e. purchases) of goods and services.
For both Tobin and Baumol the transaction demand for money depends is sensitive to rate of interest; interest
represents the opportunity cost of holding money instead of bonds, saving and fixed deposits. The higher the rate
of interest, the greater the opportunity cost of holding money. There is also a benefit to holding money, the
avoidance of transaction costs.
In 1956, Milton Friedman developed a theory of the demand for money in the article “The quantity theory of
money: a restatement”, in which he expressed his formulation of the demand for money:
According to Friedman, individuals
hold money for the services it provides
to them. His approach to demand for
money, unlike Keynes’, does not
consider any motives for holding
money, nor does it distinguishes
between speculative and transactions
demand for money. The demand for
money is considered merely as an
application of a general theory of
demand for capital assets.
Friedman, unlike Keynes, including many assets as alternatives to money, recognized that more than one interest
rate is important to the operation of the aggregate economy. Also, he viewed money and goods as substitutes,
the public chooses between them when deciding how much money to hold.
Unlike Keynes’s theory, which indicates that interest rates are an important determinant of the demand for
money, Friedman’s theory suggests that changes in interest rates should have little effect on the demand for
money; because changes in interest rates should have little effect on incentives for holding other assets relative
to money, these incentive terms remain relatively constant, because any rise in the expected returns on other
assets as a result of the rise in interest rates would be matched by a rise in the expected return on money. So
Friedman’s money demand function, in which permanent income is the primary determinant of money demand
can be approximated by:
Another issue stressed by Friedman was the stability of the demand for money function. Demand
for money can be predicted accurately by the money demand function, combined with his view
that the demand for money is insensitive to changes in interest rate, this means that velocity is
highly predictable, yielding a quantity theory conclusion that money is the primary determinant of aggregate
spending. The conclusion that money is the primary determinant of aggregate spending was the basis of
monetarism, the view that the money supply is the primary source of movements in the price level and aggregate
output.
1. Chiarire il concetto di “trappola della liquidità”
1. An extreme case of ultra-sensitivity of the demand for money to interest rates in which monetary policy has no
direct effect on aggregate spending, because a change in the money supply has no effect on interest rates. An
increase in money supply fails to generate a fall in the interest rate because there’s an inferior limit to it; when
nobody is willing to hold bonds and all the public want just money.
At negative nominal interest rates, people would find money strictly preferable to bonds, and bonds therefore
would be in excess supply. In this situation macroeconomic policy makers are trapped in a situation where they
may no longer be able to steer the economy through conventional monetary expansion. Economists therefore
recommend that if possible, central banks avoid the zero lower bound (ZLB) on the nominal interest rate.
Starting in 2014, several major central banks, most prominently the ECB, started to push nominal interest rates
into negative teerritory, effectively by charging commercial banks on the cash they hold at the central bank.
The dilemma a central bank faces when the economy is in a liquidity trap slowdown can be seen by considering
the interest parity condition (Equilibrium in the foreign exchange market, i.e. deposits of all currencies must offer
the same expected rate of return when returns are measured in comparable terms) when the domestic interest
rate R = 0,
Assuming for the moment that the expected future exchange rate Ee, is fixed. Supposing the central bank raises
the domestic money supply so as to deprecite the currency temporarily (that is, to raise E today but return the
exchange rate to the level Ee later).
Thhe interest parity condition shows that E cannot rise once R = 0 because the interest rate would have to become
negative, Instead, despite the increase in the mmoney supply, the exchange rate remains steady at the level
The second term in the Phillips curve equation shows that cyclical unemployment, the deviation of
unemployment from its natural rate, exerts upward or downward pressure on inflation. Low unemployment
pulls the inflation rate up. This is called demand-pull inflation because high aggregate demand is responsible
for this type of inflation. High unemployment pulls the inflation rate down.
The third term shows that inflatjion also rises and falls because of supply shocks. An adverse supply shock
implies a positive value and causes inflation to rise. This is called cost-push inflation.
Considering the options the PC curve gives to a plicymaker who can influence aggregate demand with
monetary or fiscal policy. At any moment, expected inflation and supply shocks are beyond the policymaker’s
immediate control. Yet, by chanign aggregate demand, the policymaker can alter output, unemployment, and
inflation. The policymaker can expand aggregate demand to lower unemployment and raise inflation, or
depress aggregate demand to raise unemployment and lower inflation.
6. Il governo di un paese che è in regime di cambi fissi opera un’espansione fiscale. Si descrivano gli effetti sulle
principali variabili macroeconomiche, utilizzando il modello IS-LM. Come cambia la dinamica descritta se il paese
in questione è non in regime di cambi fissi ma membro dell’unione monetaria europea in cui le politiche fiscali
sono rimaste nazionali ma la politica monetaria è unica. (de Grauwe)
6. Answer: