Chapter 4: Money, Prices, and Interest PDF

METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS LECTURE NOTES Chapter 4: Money, Prices, and Interest 1. The Quantity Theory of Money  The price level is relationship between the level of output and the quantity of money o We need to add money to the model ...

METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS LECTURE NOTES Chapter 4: Money, Prices, and Interest 1. The Quantity Theory of Money  The price level is relationship between the level of output and the quantity of money o We need to add money to the model  The equation of exchange o Focuses on money supply o All transactions o  M: quantity of money  VT: money velocity of all transactions (money turnover)  PT: Price level of all transactions  T: Total transactions in the economy o Income transactions o  M: quantity of money  V: income velocity of money (purchase of currently produced final goods and services)  P: Price index (not price level) for currently produced final goods and services  Y: Real output (GDP)  Remember that ∑   Therefore:  If , then P is the price vector of all goods included in the vector Q  Cambridge approach o Focuses on money demand o ( ) d  M : Money demand  k: Proportion of nominal income (PY) that is demanded as cash-holding  P: Price index  Y: Real output Page 1 of 9 METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS  In equilibrium money supply equals money demand, then o o o o o Money velocity is the inverse of money demand  Quantity theory of money o Add to the equation of exchange the following assumptions:  Money demand, and therefore V, are constant  Output (Y) cannot change fast in the short run  Then, because M is exogenous, P depends on money supply (don’t forget: assuming money demand is constant) ̅ o ̅ ̅ ̅  Important: o Monetary equilibrium depends on all transaction that take place in the economy, not only purchases of final goods and services: is more accurate o If during a cycle is not constant then to follow Y rather than T can underestimate monetary disequilibrium o Because T was not observable but Y was, quantity theory of money uses Y rather than T. o Some countries, such as the U.S., provide measures that track more closely all transactions  Gross Output: ( )  Gross Domestic Expenditures: ( )  According to GDP, consumption is the variable that drives the economy  According to GO, investment is the variable that drives the economy  The Classical Aggregate Demand (AD) Curve o The quantity theory of money is the implicit theory of aggregate demand o AD = MV (total nominal spending) o  With a given level of output, AS and AD determine the price level o Page 2 of 9 METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS Page 3 of 9 METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS 2. The Classical Theory of the Interest Rate  Equilibrium interest rate: rate at which desire to lend and desire to borrow are equal o The interest rate is the cost of borrowing  Investment depends on expected profits and the rate of interest o All else equal, investment varies inversely with interest rates (cost of borrowing to invest)  Credit/loan market o Demand side: firms and government (inverse relationship with interest rate) o Supply side: savers (positive relationship with interest rates)  Assume interest rate r falls because investment falls (demand shifts to the left): o Quantity of savings decrease and therefore consumption increases o Investment quantity increases due to the fall in the interest rate  Two reasons why there is full employment in Classical macroeconomics o AS is vertical (see previous chapter) o Because the interest rate makes S = I  What is not saved/invested is consumed Page 4 of 9 METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS Page 5 of 9 METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS 3. Policy Implications of the Classical Equilibrium Model  Fiscal policy (changes in G). Assume the budget is in equilibrium (no deficit nor surplus) o Government spending  Three sources to finance a deficit: (1) taxes, (2) debt, (3) money creation  The model assumes perfect Ricardian equivalence:  If government cut taxes permanently then consumers know that in the future they will have to pay taxes to pay-off the new debt. Therefore consumption falls today by the same present value than the debt and there is no effect in AD  If government cut taxes and is expected that spending will fall accordingly in the near future then consumption falls less and there is an effect in AD because YD is expected to raise o It is a fall in G, not a fall in taxes, what increases real income in the private sector  Debt increase  If government debt increases, it still the case that S = I and then output doesn’t change. There is a change in the components of GDP, not in the level of GDP  Because output does not change, the price level does not change  Crowding out effect: The deficits crowds out the same amount of resources from the private sector (consumption and investment.) Private investment falls even if total savings increase when the government deficit increases  See figure 4-5 below  Tax policy  Effects on demand do not affect the price level (remember AS is vertical)  Effects on supply affects the price level because output changes o [( ) ] o See figure 4-6 below  Money creation  P changes in the same proportion than M  It does not matter (for P) where does the money enter the market  Monetary policy (changes in M) o Important: M defines P and the level of nominal income (subject to Y and money demand) o Not important: The level of output and employment does not depend on the quantity of money. Money is neutral in the sense that equilibrium real values [ ( ) ] do not depend on M Page 6 of 9 METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS Page 7 of 9 METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS Page 8 of 9 METROPOLITAN STATE UNIVERSITY OF DENVER INTERMEDIATE MACROECONOMICS 4. Model example  See the Macroeconomic Models spreadsheet in Blackboard  Model functions o (̅ ) o ( ) o Labor demand depends on the firm maximizing profits  ̅  ( ) ( )  ( ) ( ) ( )  [ ] ( ) ( )  Labor market equilibrium condition o ( ) o ( ) [ ] ( ) o do some math…. o ( ) [( ) ] [( ) ]  Assume: o A = 100 o K=1 o α = 0.5 o c=0 o d = 3.5  Then: o ( ) o o o  Use the spreadsheet to apply shocks to the model o Can you predict the results? o Can you explain the “economic intuition” behind the shock effect? Page 9 of 9