MACROECONOMICS

Monetary Policy

Ekonomi Makro Kelas A

Week #9, 18 April 2022
 Monetary Policy

The Demand for Money

the demand for money is the desired holding of

financial assets in the form of money (cash or bank
deposits)

 what about the relationship between the level of

the interest rate to the demand for money
Some Considerations

1) Money provides liquidity which creates a trade-off

between the liquidity advantage of holding money and
the interest advantage of holding other assets
2) The quantity of money demanded varies inversely with
the interest rate
3) While the demand of money involves the desired
holding of financial assets, the money supply is the total
amount of monetary assets available in an economy at a
specific time
4) Central Bank controls the money supply
 In economics, the demand for money is generally
equated with cash or bank demand deposits. Generally,
the nominal demand for money increases with the level
of nominal output and decreases with the nominal
interest rate
 The equation for the demand for money is:
Md= P * L(R,Y). This is the equivalent of stating that the
nominal amount of money demanded (Md) equals the
price level (P) times the liquidity preference function
L(R,Y) the amount of money held in easily convertible
sources (cash, bank demand deposits). Specific to the
liquidity function, L(R,Y), R is the nominal interest rate
and Y is the real output.
 Money is necessary in order to carry out transactions.
However inherent to the holding of money is the trade-
off between the liquidity advantage of holding money
and the interest advantage of holding other assets.
 When the demand for money is stable, monetary policy
can help to stabilize an economy. However, when the
demand for money is not stable, real and nominal
interest rates will change and there will be economic
fluctuations.
Impact of the Interest Rate
The interest rate is the rate at which interest is paid by a
borrower (debtor) for the use of money that they borrow from
a lender (creditor).

It is viewed as a “cost” of borrowing money. Interest-rate

targets are a tool of monetary policy. The quantity of money
demanded varies inversely with the interest rate.

Central banks in countries tend to reduce the interest rate

when they want to increase investment and consumption in
the economy.
However, low interest rates can create an economic bubble
where large amounts of investments are made, but result in
large unpaid debts and economic crisis.

The interest rate is adjusted to keep inflation, the demand for

money, and the health of the economy in a certain range.

Capping or adjusting the interest rate parallel with economic

growth protects the momentum of the economy.
Control of the Money Supply
While the demand of money involves the desired holding of
financial assets, the money supply is the total amount of
monetary assets available in an economy at a specific time.
Money supply affects the price level, inflation, the exchange
rate, and the business cycle.
Monetary policy also impacts the money supply. Expansionary
policy increases the total supply of money in the economy
more rapidly than usual. Contractionary policy expands the
supply of money more slowly than normal.
Expansionary policy is used to combat unemployment, while
contractionary is used to slow inflation.
Shifts in the Money Demand Curve

A shift in the money demand curve occurs when there is a

change in any non-price determinant of demand, resulting in a
new demand curve.
Thoughtful Variables

1) Demand for Money

The real demand for money is defined as the nominal
amount of money demanded divided by the price level.
The nominal demand for money generally increases with
the level of nominal output (the price level multiplied by
real output).

The interest rate is the price of money. The quantity of

money demanded increases and decreases with the
fluctuation of the interest rate.

The real demand for money is defined as the nominal

amount of money demanded divided by the price level.
2) Factors that Cause Demand to Shift

A demand curve has the price on the vertical axis (y)

and the quantity on the horizontal axis (x).

The shift of the money demand curve occurs when there is

a change in any non-price determinant of demand,
resulting in a new demand curve.

Non-price determinants are changes cause demand to

change even if prices remain the same.
Factors that influence prices include:

 Changes in disposable income

 Changes in tastes and preferences
 Changes in expectations
 Changes in price of related goods
 Population size
 Factors that change the demand include:

 Decrease in the price of a substitute

 Increase in the price of a complement
 Decrease in consumer income if the good is a
normal good
 Increase in consumer income if the good is an
inferior good

The demand for money shifts out when the nominal level of
output in-creases. It shifts in with the nominal interest rate.
Implications of Demand Curve Shift

The demand for money determines how a person’s wealth

should be held. When the demand curve shifts to the right
and increases, the demand for money increases and
individuals are more likely to hold on to money.

The level of nominal output has increased and there is a

liquidity advantage in holding on to money. Likewise, when the
demand curve shifts to the left, it shows a decrease in the
demand for money. The nominal interest rate declines and
there is a greater interest advantage in holding other assets
instead of money.
The Equilibrium Interest Rate

In a economy, equilibrium is reached when the supply of

money is equal to the demand for money. The concept of
market equilibrium is used to explain changes in the interest
rate and money supply.
Interest Rate

1) The interest rate is the rate at which interest is paid by a

borrower(debtor) for the use of money that they borrow
from a lender (creditor).

2) Equilibrium is reached when the supply of money is

equal to the demand for money. Interest rates can be
affected by monetary and fiscal policy, but also by
changes in the broader economy and the money supply.
Factors that Influence the Interest Rate

Within an economy, there are numerous factors that contribute

to the level of the interest rate.

 Political gain: both monetary and fiscal policies can

affect the money supply and demand for money.
 Consumption: the level of consumption (and changes
in that level)affect the demand for money.
 Inflation expectations: inflation expectations affect a
the willingness of lenders and borrowers to transact at
a given interest rate. Changes in expectations will
therefore affect the equilibrium interest rate.
 Taxes: changes in the tax code affect the willingness of
actors to invest or consume, which can therefore
change the demand for money.
Market Equilibrium

Equilibrium is a state where economic forces such as supply

and demand are balanced and without external influences.

Market equilibrium refers to a condition where a market

price is established through competition where the amount
of goods and services sought by buyers is equal to the
amount of goods and services produced by the sellers.

In the case of money supply, the market equilibrium exists

where the interest rate and the money supply are balanced.
The money supply is the total amount of monetary assets
available in an economy at a specific time. Without external
influences.