Investment function

Money Demand and Money Supply

 Financial Institutions
• Financial system
– Group of institutions in the economy that help to match
one person’s saving with another person’s investment
• Financial institutions
– Institutions through which savers can directly provide
funds to borrowers
1. Financial markets
2. Financial intermediaries

2
 Financial Markets
• Financial markets
– Financial institutions through which savers
can directly provide funds to borrowers
– The bond market
– The stock market

3
 Financial Intermediaries – 1
• Financial intermediaries
– Financial institutions through which savers can indirectly
provide funds to borrowers
– Banks
– Mutual funds

4
 Banks
• Primary role for banks:
– Take in deposits from savers (small interest rate)
– Use these deposits to make loans to borrowers
(charge a higher interest rate)
• Secondary role of banks:
– Facilitate purchases of goods and services
• Checks and debit cards to access deposits
• Medium of exchange
• Store of value

5
 Mutual Funds
• Mutual funds:
– Sell shares to the public and use the proceeds to
buy a portfolio of stocks and bonds
• Advantages:
– Allow people with small amounts of money to
diversify their holdings (less risk)
– Give ordinary people access to the skills of
professional money managers
• Financial economists, skeptical: hard to “beat
the market”

6
 Case
1. Explain money and social conventions on the island of
Yap

2. How does modern bitcoin resembles the primitive money

of Yap?

3. How far Bitcoin succeeds in performing the functions of

money, that is, a store of value, a unit of account, and medium
of exchange?
Numerical
• Q. Suppose we have an economy described by the following functions:

• t = 0.20

a. Calculate the level of equilibrium income and the multiplier

b. Calculate also the budget surplus, BS.

c. Suppose that t increases to 0.25. What is the new equilibrium income? The new multiplier?

d. Calculate the change in the budget surplus. Would you expect the change in the surplus to be more or less if c = 0.9 rather than 0.8?

e. Can you explain why the multiplier is 1 when t = 1?

 Some Important Identities – 2
• Assume closed economy: NX = 0
Y = C + I + G, so I = Y – C - G
• National saving (saving), S = Y – C - G
• Total income in the economy that remains after paying for
consumption and government purchases
• By definition: S = Y – C – G
• It follows: Saving (S) = Investment (I) for a closed
economy

9
 Some Important Identities – 3
• Define T = taxes minus transfer payments
S = Y – C – G can be rewritten as:
S = (Y – T – C) + (T – G)
• Private saving = Y – T – C
– Income that households have left after paying for
taxes and consumption
• Public saving = T – G
– Tax revenue that the government has left after
paying for its spending
National saving (S) = Private saving + Public saving
10
 Budget Surplus or Deficit
• Budget surplus: T – G > 0
– Excess of tax revenue over government spending = public
saving (T-G)
• Budget deficit: T – G < 0
– Shortfall of tax revenue from government spending = –
(public saving) = G – T

11
Active Learning 1: Applying the concepts
You have the following information: GDP = $19
trillion, C = $13 trillion, G = $2.5 trillion, and Budget
deficit = $1.2 trillion.
A. Find public saving, net taxes, private saving,
national saving, and investment.
B. Government cuts taxes by $300 billion. Find
new budget deficit and answers to A. if:
a) Consumers save the entire tax cut
b) Consumers save 1/3 and spend the other 2/3
of the tax cut

12
Active Learning 1: Answers, A
Y = $19 tn., C = $13 tn. G = $2.5 tn., and Budget
deficit = G – T = $1.2 tn.
• Public saving = T – G = – $1.2 tn.
• Net taxes T = $1.3 tn.
G – T = 1.2, G = 2.5, So T = 2.5 – 1.2 = 1.3
• Private saving = $4.7 tn.
= Y – T – C = 19 – 1.3 – 13 = 4.7
• National saving = investment, S = I = $3.5 tn.
S = Y – C – G = 19 – 13 – 2.5 = 3.5
S = private + public saving = 4.7 – 1.2 = 3.5

13
Active Learning 1: Answers, B: Tax cut = $0.3 tn.
a) consumers b) consumers save 1/3
save the tax cut and spend 2/3 of tax cut
Increase in C: 0 2/3 of 0.3 tn. = $0.2 tn.
Net taxes, T 1.3 - .3 = $1 tn. It ↓by $0.3 tn.
Budget deficit 1.2 + 0.3 = $1.5 tn.
=G–T It ↑ by the tax cut of $0.3 tn.
Public saving = - $1.5 tn.
=T–G = - budget deficit
Private saving $5 tn. $4.8 tn.
=Y–T–C It ↑ by $0.3 tn. It ↑ by $0.1 tn.
National saving, S $3.5 tn. $3.3 tn.
= Investment, I Unchanged It ↓ by $0.2 tn.
=Y–C–G

14
 The Meaning of Saving and Investment – 1
• Private saving
– Income remaining after households pay their taxes and
pay for consumption.
– Examples of what households do with saving:
• Buy corporate bonds or equities
• Purchase a certificate of deposit at the bank
• Buy shares of a mutual fund
• Let accumulate in saving or checking accounts

15
The Meaning of Saving and Investment – 2
• Investment
– Is the purchase of new capital
– Examples of investment:
• General Motors spends $250 million to build
a new factory.
• You buy $5,000 worth of computer equipment
for your business.
• Your parents spend $300,000 to have a new
house built.
Investment is NOT the purchase of stocks and bonds!

16
 The Market for Loanable Funds – 1
• Market for loanable funds
– The market in which those who want to save supply funds and
those who want to borrow to invest demand funds
– A supply–demand model of the financial system
– Helps us understand:
• How the financial system coordinates
saving & investment.
• How government policies and other factors affect saving,
investment, the interest rate.

17
 The Market for Loanable Funds – 2
• Assume: only one financial market
– All savers deposit their saving in this market.
– All borrowers take out loans from this market.
– There is one interest rate, which is both the return to
saving and the cost of borrowing.

18
 The Supply of Loanable Funds
• Saving is the source of the supply of loanable funds:
– Households with extra income can loan it out and earn interest.
– Public saving
• If positive, adds to national saving and the supply of loanable
funds.
• If negative, it reduces national saving and the supply of loanable
funds.

19
 The slope of the supply curve
An increase in the
interest rate makes
Interest
Rate Supply
saving more
attractive, which
increases the
6%
quantity of loanable
funds supplied.

3%

60 80 Loanable Funds
($ billions)

20
 The Demand for Loanable Funds
• Investment is the source of the demand for loanable
funds:
– Firms borrow the funds they need to pay for new
equipment, factories, etc.
– Households borrow the funds they need to purchase new
houses.

21
 The slope of the demand curve
A fall in the interest rate
Interest
reduces the cost of
Rate borrowing, which
increases the quantity
7%
of loanable funds
demanded.
4%

Demand

50 80 Loanable Funds
($ billions)

22
Equilibrium on the market for loanable funds
Interest The interest rate
Rate adjusts to equate
Supply
supply and demand.
The equilibrium
quantity of loanable
5% funds = equilibrium I
= equilibrium S.

Demand

60 Loanable Funds ($
billions)

23
 Reaching Equilibrium
• If interest rate < equilibrium:
– QS < QD, so shortage of loanable funds
• Encourage lenders to raise the interest rate
• Encourage saving (increase QS)
• Discourage borrowing for investment (decreasing QD)
• If interest rate > equilibrium:
– Surplus of loanable funds
– Decrease interest rate

24
 Policy 1: Saving Incentives
Interest • Tax incentives for
Rate
saving increase the
S1 S2 supply of loanable
funds
• …which reduces the
5% equilibrium interest
4% rate
• and increases the
D1 equilibrium quantity
of loanable funds
60 70 • greater S and I
Loanable Funds
($ billions)
25
 Policy 2: Investment Incentives
Interest • An investment tax
Rate
credit increases the
S1 demand for loanable
funds
6% • …which raises the
5% equilibrium interest
rate
D2 • and increases the
D1 equilibrium quantity
of loanable funds
60 70 • greater S and I
Loanable Funds
($ billions)
26
Policy 3: Government Budget Deficits and Surpluses
• Budget deficit G > T
– Excess of government spending over tax revenue
• Government debt
– Accumulation of past government borrowing
• Budget surplus, T > G
– Excess of tax revenue over government spending
– Repay some of the government debt.
• Balanced budget: G = T

27
Active Learning 2: Budget deficits and surpluses
Assume the government starts with a balanced budget and then,
because of an increase in government spending (and/or decrease in
taxes), starts running a budget deficit. Use the loanable funds model to
analyze the effects of a government budget deficit:
A. Draw the diagram showing the changes in equilibrium. What
happens to the equilibrium values of the interest rate and
investment?
B. Analyze the effects of a budget surplus.

28
Active Learning 2: Answers
Interest A. A budget deficit reduces
Rate
S2 national saving and the
S1 supply of loanable funds
…which increases the
6% equilibrium interest rate
5% and decreases the equilibrium
quantity of loanable funds and
investment.
D1 B. A budget surplus increases
the supply of loanable
funds, reduces the interest
50 60
rate, and stimulates
Loanable Funds
($ billions) investment.
29
 Policy 3: Lessons
• Budget deficits
– Reduce national saving
– Decrease the supply of loanable funds
– Interest rate rises and investment falls
• Budget surplus
– Increase national saving
– Increase the supply of loanable funds
– Reduce the interest rate, and stimulates investment

30
 THINK-PAIR-SHARE
You are watching a presidential debate. When a
candidate is questioned about his position on economic
growth, the presidential candidate steps forward and
says, “We need to get this country growing again. We
need to use tax incentives to stimulate saving and
investment, and we need to get that budget deficit down
so that the government stops absorbing our nation’s
saving.”
A. If G remains unchanged, what inconsistency is
implied by the presidential candidate’s statement?
B. If the presidential candidate truly wishes to decrease
taxes and decrease the budget deficit, what has the
candidate implied about his plans for G?
Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31
 Finance
• The financial system
– Coordinates saving and investment
• Participants in the financial system
– Make decisions regarding the allocation of resources over time
and the handling of risk
• Finance
– Studies how people make decisions regarding the allocation of
resources over time and the handling of risk

32
 Present Value
• The present value of a future sum:
– The amount of money today (PV) needed to produce a
future amount of money (FV), given prevailing interest
rates
• The future value of a sum:
– The amount of money in the future (FV) that an amount of
money today (PV) will yield, given prevailing interest rates

33
EXAMPLE 1: Grandma’s Gift
Demarcus received $200 from grandma for
his birthday. He wants to deposit the money in
the bank at 5% interest.
What is the future value (FV) of this amount?
• Present value, PV = $200
• Interest rate, r = 0.05
• In one year, FV = $200×(1 + 0.05) = $210.00
• In two years, FV = $200×(1 + 0.05)2 = $220.50
• In three years, FV = $200×(1 + 0.05)3 = $231.53
• In N years, future value FV = PV×(1 + r)N

34
EXAMPLE 2: How much to save?
Amaia inherited money from her aunt’s estate.
She wants to travel for now, but also to save
some of the money to pay for grad school in 4
years.
If the interest rate is 8%, how much does she
need to deposit today to have $20,000 in 4
years?
• We need to find PV of $20,000 (FV), r = 0.08, N = 4
• We know FV = PV×(1 + r)N so, PV = FV / (1 + r)N
• PV = $20,000 / (1+0.08)4 = $14,700.60

35
 Compounding and the Rule of 70
• Compounding:
– The accumulation of a sum of money where the interest earned
on the sum earns additional interest
• Because of compounding
– Small differences in interest rates lead to big differences over
time.
• The Rule of 70:
– If an amount grows at a rate of x % per year, that amount will
double in about 70/x years.

Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36
EXAMPLE 3: Compounding and the rule of 70
You buy $1,000 worth of Microsoft stock and hold it
for 30 years.
• If rate of return = 0.08,
• FV = PV×(1 + r)N = $1,000×(1 + 0.08)30 = $10,063
• The $1,000 will double in 70/8 = 8.75 years
• If rate of return = 0.10,
• FV = $1,000×(1 + 0.10)30 = $17,450
• The $1,000 will double in 70/10 = 7 years
• Thus, a 2 percentage points difference in the rate
of return (from 8% to 10%) leads to over $7,000 of
additional interest earned over the 30 years.
37
EXAMPLE 4: Investment decision
Pacific Gas & Electric wants to build a new power
plant that will generate $800 million in ten years.
The plant costs $400 million to build. Should PG&E
build the plant if:
a) Interest rate is 4%? Why?
b) Interest rate is 8%? Why?
We need to find PV of $800 million in 10 years:
a) PV = ($800 million)/(1.04)10 = $540,451.30
• Since cost < PV, PG&E should build it
b) PV = ($800 million)/(1.08)10 = $370,544.80
• Since cost > PV, PG&E should NOT build it
38
Active Learning 1: Buying land to sell later
Makayla is thinking of purchasing a twelve-
acre lot for $70,000. The lot will be worth
$120,000 in ten years.
A. Should Makayla buy the lot if r = 0.03?
B. Should Makayla buy it if r = 0.07?

A. PV = ($120,000)/(1.03)10 = $89,291.27
• Since price < PV, Makayla should buy it
B. PV = ($120,000)/(1.07)10 = $61,001.92
• Since price > PV, Makayla should NOT buy it

39
 The Desired Capital Stock
• Firms use capital, along with labor and other resources, to produce
output  The goal of a given firm is to maximize profits
®When deciding the optimal level of capital, firms must balance
the contribution that more capital makes to their revenues
against the cost of acquiring additional capital
®The marginal product of capital is the increase in output produced
by using one more unit of capital in production
®The rental (user) cost of capital is the cost of using one more unit
of capital in production

15-40
 The Desired Capital Stock
• To derive the rental cost of capital:
– firms finance the purchase of capital by borrowing over time, at an
interest rate of i
– In the presence of inflation, the nominal dollar value of capital
rises over time
– At the time the firm makes an investment, the nominal interest
rate is known, but the inflation rate for the coming year is not
– Capital wears out over time  must include depreciation, d
– The complete formula for the rental cost of capital is:
rc  r  d  i   e  d

15-41
 The Desired Stock of Capital
• Firms add capital until the
marginal return of the last
unit = rental cost of capital
– Diminishing marginal
product of capital
– An increase in the rental cost
of capital can only be
justified by an increase in the
marginal product of capital
and a lower level of K
• The general relationship
among the desired capital
stock, K*, rc, and output is
K *  g ( rc , Y ) (1)

15-42
 From Desired Capital Stock to Investment
• At the initial level of capital, K0, price of capital just high enough to generate enough
investment, I0, to replace the depreciating capital
• In the LR, supply of new capital is very elastic; increase in demand is met without much
change in price
• In the SR, price rises to P1, increasing investment flow to I1

15-43
 Capital Stock Adjustment
• The flexible accelerator model can be used to explain the speed at which firms plan
to adjust their capital stock
 Basic notion: the larger the gap between the existing capital stock and the desired
capital stock, the more rapid a firm’s rate of investment
 Firms plan to close a fraction, , of the gap between the actual and desired capital stocks
each period
• Capital at the end of last period is K -1
• The gap between actual and desired capital stock is (K *- K-1)
• A firm plans to add a fraction of the gap to last periods stock
• Actual capital stock at the end of the current period is then

K 0  K 1   ( K *  K 1 ) (2)

15-44
 Capital Stock Adjustment
• To increase the capital stock
from K-1 to K0, the firm must
achieve net investment of:
I  ( K 0  K 1 )
 ( K 1   ( K *  K 1 ))  K 1
  ( K *  K 1 ) (3)

• Figure 15-5 illustrates how the

capital stock adjusts from an
initial level of K-1 to the
desired level K*
– Upper panel shows the stock
of capital
– Lower panel shows the
corresponding level of I

15-45
 Capital Stock Adjustment
• To increase the capital stock
from K-1 to K0, the firm must
achieve net investment of:
I  ( K 0  K 1 )
 ( K 1   ( K *  K 1 ))  K 1
  ( K *  K 1 ) (3)

• Equation (3) shows investment

spending as a function of K*
and K-1
– Any factor that increases K*,
increases the rate of
investment
– Investment contains aspects of
dynamic behavior

15-46
 Investment Subsectors
• Figure 15-6 demonstrates the volatility of the three investment subsectors:
1. Business fixed investment
2. Residential investment
3. Inventory investment

15-47
 The Meaning of Money – 1
• Barter
– Exchange one good or service for another
– Requires a double coincidence of wants: unlikely
occurrence that two people each have a good or service
the other wants.
– Waste of resources: people spend time searching for
others to trade with
• Using money
– Solves those problems
48
 The Meaning of Money – 2
• Money
– The set of assets in an economy that people regularly use
to buy goods and services
• Money has three functions:
– Medium of exchange, a unit of account, and a store of
value.
– Distinguish money from other assets

49
 The Functions of Money
1. Medium of exchange
– Item that buyers give to sellers when they want to purchase
goods and services
2. Unit of account
– Yardstick people use to post prices and record debts
3. Store of value
– Item that people can use to transfer purchasing power from
the present to the future

50
 The Kinds of Money
• Commodity money:
– Money that takes the form of a commodity with intrinsic
value
• The item would have value even if it were not used as money
• Gold coins, cigarettes in POW camps
• Fiat money:
– Money without intrinsic value, used as money because of
government decree
• The U.S. dollar

51
 The Money Stock
• M1 includes
– Currency, demand deposits at banks, some other
liquid deposits (balances in savings accounts)
• M2 includes
– Everything in M1 plus small time deposits and
money market funds (except those held in
restricted retirement accounts).
The money stock includes not only currency but also
deposits in banks and other financial institutions that
can be readily accessed and used to buy goods and
services.
52
Active Learning 1: Calculating the money stock
Suppose the entire economy has:
• $150 dollars kept in coffee cans and wallets
• $300 in saving accounts
• $200 in credit card limits
• $350 in checking accounts
• $75 in time deposits
• $175 in restricted retirement accounts
• $400 in money market funds
Calculate the money stock M2.

53
Active Learning 1: Answers
• Money stock M2 = (Currency + Demand
deposits + Other liquid deposits like savings
accounts ) + small time deposits + money
market funds

• M2 = (150 + 350 + 300) + 75 + 400

= $1,275

54
 The Reserve Bank of India
• Central bank
– An institution designed to oversee the banking system and
regulate the quantity of money in the economy
– What are the roles of Reserve Bank?

\ 55
 The Reserve Bank’s Jobs
1. Regulate banks, ensure the health of the banking
system
– Monitors each bank’s financial condition
– Facilitates bank transactions (clearing checks)
– A bank’s bank: makes loans to banks; lender of
last resort
2. Control the money supply (quantity of money
available in the economy)
– Connected to level of interest rates in short run.
– Monetary policy: decisions concerning the
money supply and interest rates
56
EXAMPLE 3: Monetary policy
To raise fed funds Federal Federal Funds market
rate, Fed sells funds
government bonds rate, rf S2 S1
(OMO).
• This removes 1.75%
reserves from the
1.50%
banking system,
reduces supply of
federal funds,
• causes rf to rise. D1
F
F2 F1
Quantity of federal funds
57
 2020 Inflation Rate
• Variations across countries
– 1.2 percent in the United States
– 0 percent in Japan
– 3.4 percent in Mexico
– 11 percent in Nigeria
– 12 percent in Turkey
– 32 percent in Argentina
• Hyperinflation: “So, what’s it going to
be? The same size as
– Extraordinarily high rate of last year or the same
inflation price as last year?”

58
 The Classical Theory of Inflation
Prices rise when the government prints too much money.
– Most economists rely on the quantity theory of money to explain
long-run determinants of the price level and the inflation rate
• Asserts that the quantity of money determines the value of
money
• We study this theory using two approaches:
1. A supply-demand diagram
2. An equation

59
 Level of Prices and Value of Money
• Price level, P: Number of dollars needed to buy a basket of goods
and services
– When the price level rises, people have to pay more for the goods
and services they buy.
• Value of money, 1/P: The quantity of goods and services that can be
bought with $1
– A rise in the price level: lower value of money because each dollar
in your wallet now buys a smaller quantity of goods and services.
Inflation drives up prices and drives down the value of money.

60
EXAMPLE 1: The cupcake
Imagine a market basket that has only one good, one
cupcake. In 2021, the price of the cupcake is P = $4. In 2022,
the price increases to P = $5.
A. What is the value of money in 2021?
B. What is the value of money in 2022?
C. Explain the inflation from 2021 to 2022 using the value of
money.

61
EXAMPLE 1: Answers
Market basket = 1 cupcake. P2021= $4. P2022= $5
A. 2021, price of the cupcake P = $4
Value of money is 1/P = ¼ (with $1, we can buy 1/4th of
a cupcake).
B. 2022, price increases to P = $5
Value of money = 1/P = 1/5 (with $1 we can buy 1/5th of
a cupcake)
C. Inflation: The value of money drops because each
$1 now buys a smaller quantity of goods and
services. In 2021, $1 bought one-fourth of a
cupcake, in 2022, the same $1 buys only one-fifth of
a cupcake.
62
 The Money Supply-Demand Diagram – 1
Value of Price
Money, 1/P Level, P
(High) As the value of money (Low)
rises, the price level falls.
1 1

¾ 1.33

½ 2

¼ 4
(Low) (High)
Quantity
of Money
63
 The Money Supply-Demand Diagram – 2
Value of Price
Money
Money, 1/P Level, P
Supply
(High) (Low)
MS1
1 1

¾ 1.33

The Reserve Bank

½ 2
sets MS
at some fixed value,
¼ 4
regardless of P.
(Low) (High)
$1,000 Quantity
of Money
64
 The Money Supply-Demand Diagram – 3
Value of Price
Money, 1/P A fall in value of money (or Level, P
(High)
increase in P) increases the (Low)
quantity of money demanded:
1 1

¾ 1.33

½ 2
Money
demand
¼ 4
MD1
(Low) (High)
Quantity
of Money
65
 The Equilibrium Price Level
Value of Price
Money, 1/P Level, P
MS1 P adjusts to equate
(High) quantity of money (Low)
demanded with
1 1
money supply.
¾ 1.33
eq’m
value A eq’m
½ 2 price
of
money level
¼ 4
MD1
(Low) (High)
$1,000 Quantity
of Money
66
 The Effects of a Monetary Injection
Value of If the RB Price
Money, 1/P Level, P
MS1 MS2 increases
(High) the money (Low)
supply.
1 1
Then the
¾ value of 1.33
money falls,
A and P rises.
New ½ 2
eq’m New
B eq’m
value ¼ 4
of MD1 price
money level
$1,000 $2,000 Quantity of Money

67
 A brief look at the adjustment process
Increasing money supply causes P to rise.
• At the initial P, an increase in MS causes an
excess supply of money.
• People get rid of their excess money: spend it on
goods and services or by loan it to others, who
spend it.
• Result: increased demand for goods and services.
• But supply of goods does not increase, so prices
must rise, so the quantity of money demanded
increases because people are using more dollars
for every transaction.

68
 The Quantity Theory of Money
• Quantity theory of money
– A theory asserting that the quantity of money available
determines the price level
– And that the growth rate in the quantity of money available
determines the inflation rate

69
EXAMPLE 2: The relative price of a good
The relative price of a good is the price of one
good in terms of another.
The price of a smartphone is $450, and the
price of a pepperoni pizza is $10.
• What is the relative price of a smartphone?

The relative price of a smartphone is:

= P smartphone / P pizza
= ($450/smartphone ) / ($10/pizza)
= 45 pizzas per smartphone
70
EXAMPLE 3: Real vs. nominal wage
The real wage is the price of labor relative to
the price of output.
The nominal wage, W = $15/hour (the price of
labor), and the price level, P = 5 (the price of
goods and services, so it’s $5/unit of output).
• Calculate the real wage.

• Real wage = W / P
= ($15/hour) / ($5/unit of output)
= 3 units of output per hour
71
 The Classical Dichotomy – 2
• Classical dichotomy:
– The theoretical separation of nominal and real variables
– Monetary developments affect nominal variables but not real
variables:
• If central bank doubles the money supply:
• Then all nominal variables—including prices—will double
• But all real variables—including relative prices—will remain
unchanged.

72
 The Neutrality of Money – 1
• Monetary neutrality:
– The proposition that changes in the money supply do not
affect real variables
• Doubling money supply
– Causes all nominal prices to double
– What happens to relative prices?
• No change

73
EXAMPLE 4: The neutrality of money
Initially, relative price of smartphones in terms
of pizza is
=
= 45 pizzas per smartphone
• If all prices double:
=
= 45 pizzas per smartphone
• The relative price is unchanged.

74
Active Learning 1: The neutrality of money
If the central bank doubles the money supply,
what happens with the real wage and total
employment?
• Doubling the money supply:
– Nominal wages double
– Price level doubles
– Real wage is W/P remains unchanged
– Quantity of labor supplied does not change
– Quantity of labor demanded does not change
– Total employment of labor does not change

75
 The Neutrality of Money – 2
– The classical dichotomy and neutrality of money describe
the economy in the long run.
– However, monetary changes can have important short-
run effects on real variables.

76
 The Velocity of Money
• Velocity of money:
– The rate at which money changes hands
• Notation:
P x Y = nominal GDP = (price level) x (real GDP)
M = money supply
V = velocity
• Velocity formula:
PxY
V =
M

77
EXAMPLE 5: The velocity of money
Assume there is only one good in the economy,
pizza. In 2023, money supply is $10,000, real
GDP is 3,000 pizzas, and the price of pizza is
$10. What is the velocity of money?
• Y = real GDP = 3,000 pizzas
• P = price level = price of pizza = $10
• P x Y= nominal GDP = value of pizzas = $30,000
• Velocity, V = P × Y / M = nominal GDP / money
supply = $30,000/$10,000 = 3
The average dollar was used in 3 transactions.
78
Active Learning 2: Velocity of money
Assume there is only one good in the economy,
corn. The economy has enough labor, capital,
and land to produce 1,800 bushels of corn.
V is constant. In 2023, money supply is $3,600
and the price of corn is $8/bushel.
• Compute nominal GDP and velocity in 2023.

• Nominal GDP = P x Y = $8 x 1,800 =

$14,400
• Velocity V = P x Y / M = $14,400 / $3,600 = 4

79
 The Quantity Equation
• The quantity equation: M x V = P x Y
– Relates the quantity of money (M) to the nominal value of
output (P × Y)
– Shows that an increase in the quantity of money in an
economy must be reflected in one of the other three
variables:
• The price level must rise
• The quantity of output must rise
• Or the velocity of money must fall

80
 The Quantity Theory of Money
1. V is relatively stable over time.
2. A change in M causes nominal GDP (P x Y) to change by the
same percentage.
3. A change in M does not affect Y: money is neutral, Y is
determined by technology & resources
4. So, P changes by same percentage as
P x Y and M.
5. Rapid money supply growth causes rapid inflation.

81
Active Learning 3: Quantity theory of money
Assume there is only one good in the economy,
corn. The economy has enough labor, capital,
and land to produce 1,800 bushels of corn. V is
constant. In 2023, money supply was $3,600
and the price of corn was $8/bushel. For 2024,
the Reserve Bank increases money supply, MS
by 10%.
A. Compute the 2024 values of nominal GDP and P.
Compute the inflation rate for 2023–2024.
B. Suppose tech. progress causes Y to increase to
1,950 in 2024. Compute the 2023–2024 inflation
rate.
82
Active Learning 3: Answers, A
• First, calculate velocity because it is constant from
2023 to 2024. For 2023: P x Y = M x V, so 8 ×
1,800 = 3,600 × V, therefore V = 4
• Calculate nominal GDP for 2024, knowing the
money supply increased by 10% to $3,960.
• Nominal GDP in 2024 = P x Y = M x V = 3,960 x 4 =
$15,840
• To calculate inflation rate we need the price of corn
in 2023 ($8) and in 2024: P = M x V / Y =
15,840/1,800 = $8.80
• Inflation rate 2023-2024 = (8.80 – 8.00)/8.00 = 10%
(same as money supply)
83
Active Learning 3: Answers, B
2023: Y = 1,800 bushels; P = $8 per bushel, MS = $3,600.
In 2024, MS increases by 10%. V = 4 (constant)
B. Suppose tech. progress causes Y to increase to 1,950 in 2024.
Compute the 2023–2024 inflation rate.

• 2024 prices: P = M x V / Y = 15,840/1,950 =

$8.12
• Inflation rate 2023-2024 = (8.12 – 8.00)/8.00 =
1.5%

84
 The Inflation Tax
• The inflation tax
– Revenue the government raises by creating (printing)
money
– Like a tax on everyone who holds money
• When the government prints money
• The price level rises
• The dollars in your wallet are less valuable
– In the U.S., the inflation tax today accounts for less than
3% of federal receipts

85
 The Fisher Effect – 1
• Principle of monetary neutrality
– An increase in the rate of money growth raises the rate of
inflation but does not affect any real variable
• Because
Real interest rate = Nominal interest rate – Inflation rate
• We get
Nominal interest rate = Real interest rate + Inflation rate

86
 The Fisher Effect – 2
• Fisher effect
– One-for-one adjustment of nominal interest rate to inflation
rate
– When the RB increases the rate of money growth, the
long-run result is:
• Higher inflation rate
• Higher nominal interest rate

87
 The Inflation Fallacy
• Inflation fallacy
– “Inflation robs people of the purchasing power of his hard-
earned dollars”
• When prices rise
– Buyers pay more
– Sellers get more
• Inflation does not in itself reduce people’s real
purchasing power

88
 Components of the Money Stock
• Two main monetary aggregates in U.S.: M1 and M2
─ M1 comprises those claims that can be used directly, instantly, and without restrictions →
LIQUID
─ M2 includes M1, plus some less liquid assets (ex. savings accounts and money market
funds)
• As liquidity of an asset decreases, the interest yield increases
– A typical economic tradeoff: in order to get more liquidity, asset holders have to sacrifice
yield

16-89
 Keynes’s famous three motives for
holding money:
• The theories covered here correspond to Keynes’s famous three motives for holding
money:
– The transactions motive, which is the demand for money arising from the use of money
in making regular payments
– The precautionary motive, which is the demand for money to meet unforeseen
contingencies
– The speculative motive, which arises from uncertainties about the money value of other
assets that an individual can hold

Transaction and precautionary motives → mainly discussing M1

Speculative motive → M2, as well as non-money assets

16-90
 Transaction Demand
• The transaction demand for money arises from the lack of synchronization of
receipts and disbursements
– Keep money on hand to make purchases between pay periods
• Tradeoff between amount of interest an individual forgoes by holding money and
costs of holding a small amount of money
– Benefits of keeping small amounts of money on hand is interest earned on money left
in the bank
– Cost of keeping small amounts of money is the cost and inconvenience of making
trips to the bank to withdraw more

16-91
 Transaction Demand
• Suppose the following:
– Y = $1800/month
– Person spends the Y evenly over the month, at a rate of $60/day

• Alternative 1:
– Person could keep the entire $1800 in cash and spend $60/day
– Cash balances falls smoothly from $1800 to $0 at the end of the month
– Average balance of

($1800  $0)
 $900
2
– Forgone interest of
i  $900

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 Transaction Demand
• Suppose the following:
– Y = $1800/month
– Person spends the Y evenly over the month, at a rate of $60/day

• Alternative #2:
– Person could deposit entire amount, and each day take the needed $60 out of the bank
– Earn interest on money left in the bank over the course of the month
– Cash balances fall from $1800/30 to zero every day
– Average balance of

–
$1800
Forgone interest of 30
 $0 
 $30
2
i  $30

16-93
 Transaction Demand
In general:
– Starting income of Y
– n trips to the bank
→ The average cash balance is 2Yn
– Each trips costs tc
→ The combined cost of trips plus forgone interest is:

n  tc   i  Y 2n 
– Choose n to minimize costs and compute the average money
holdings  Baumol-Tobin formula for the demand for money:

M tc  Y

P 2i (1)

16-94
 The Precautionary Motive
• The Baumol-Tobin model ignored uncertainty
– People uncertain about the payments they might want or have to make → there is
demand for money for these uncertain events
• The more money a person holds, the less likely he or she is to incur the costs of
illiquidity
– The more money a person holds, the more interest he/she will give up → similar
tradeoff encountered with transactions demand for money
• Technology and the structure of the financial system are important determinants of
precautionary demand

16-95
 Speculative Demand for Money
• Speculative demand for money focuses on the store-of-value function of money →
concentrates on role of money in the investment portfolio of an individual
• Wealth held in specific assets → portfolio
– Due to uncertainty, unwise to hold entire portfolio in a single risky asset → diversify
asset holdings
• Money is a safe asset
– Demand for money depends upon the expected yields and riskiness of the yields on
other assets (James Tobin)
 Increased opportunity costs of holding money lowers money demand
 Increased riskiness of returns on other assets increases money demand

16-96
 Empirical Estimates
• Four essential properties of money demand:
– Demand for money balances responds negatively to the rate of
interest.
– Demand for money increases with the level of real income.
– Short-run responsiveness of money demand to changes in
interest rates and income is considerably less than the long-run
response. (the long-run responses are estimated to be about 5
times the size of the short-run responses)
– Demand for nominal money balance is proportional to the price
level. There is no money illusion; in other words, the demand for
money is a demand for real balances.

16-97
 The Income Velocity
• The income velocity of money: 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 nominal GDP to the nominal money stock, or:
P Y Y (2)
V 
M M
P
 Can also be interpreted as the ratio of nominal income to nominal money stock OR the ratio of real
income to real balances

16-98
 The Income Velocity
• Concept of velocity is important largely because it is a convenient way of talking
about money demand

– Demand for real balances is: M  L (i , Y )

P

® Substituting into equation (2), velocity can be written as: V Y

L (i , Y )
® Money demand can be written as: L ( i , Y )  Y  l (i )
® Velocity of money is: V 1
l (i )

16-99
 The Income Velocity
• Figure 16-1 shows M2 velocity (left scale) and the Treasury bill interest rate (right scale)
– M2 is relatively stable
– Velocity has a strong tendency to rise and fall with market interest rates

16-100
 The Income Velocity
• Figure 16-1 shows M2 velocity (left scale) and the Treasury bill interest rate (right scale)
– M2 velocity has become much less stable
 When monetary aggregates relatively unstable, monetary authority should use the interest rate
rather than money supply as the direct operating target

16-101
 The Quantity Theory
• The quantity theory of money provides simple way to think about the relation
between money, prices, and output:
M V  P  Y (3)
– Equation (3) is the famous quantity equation, linking the price level and the level of output
to the money stock
– The quantity equation became the classical quantity theory of money with it was argued
that both V and Y were fixed

 If both V and Y are fixed, it follows that the price level is proportional to the money stock

16-102
 The Quantity Theory
• The classical quantity theory = theory of inflation
– The price level is proportional to the money stock:
V M
P (3a)
Y
– If V is constant, changes in the money supply translate into proportional changes in
nominal GDP
– With the classical case (vertical) supply function, Y is fixed, and changes in money
translate into changes in the overall price level, P

16-103