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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 39
THE PORTFOLIO DEMAND FOR MONEY
Money is just one of many financial instruments that we can hold in our investment portfolios.
Expectations that interest rates will change in the future are related to the expected return on a
bond and also affect the demand for money.
When interest rates are expected to rise, money demand goes up as people switch from holding
bonds into holding money.
The demand for money will also be affected by changes in the riskiness of other assets; as their
risk increases so does the demand for money.
Money demand will increase if other assets become less liquid.
Determinants of Money Demand: Factors that cause individuals to hold more money
Transactions Demand for Money
National Income
The higher nominal income, the higher the demand for money
Interest rates
The lower interest rates, the higher the demand for money
Availability of alternative
The less available alternatives means of payment, the higher the
means of payment
demand for money
Portfolio Demand for Money
As wealth rises, the demand for money goes up
Wealth
As the return on alternatives falls, the demand for money goes up
Return relative to alternatives
As expected future interest rates rise, the demand for money goes up
Expected future interest rates
As the riskiness of alternatives rises, the demand for money goes up
Risk relative to alternatives
As the liquidity of alternatives falls, the demand for money goes up
Liquidity relative
Targeting Money Growth in a Low-Inflation Environment
In the long run, inflation is tied to money growth.
In a high-inflation environment moderate variations in the growth of velocity are a mere
annoyance.
The only solution to inflation in a high inflation environment is to reduce money growth.
In a low-inflation environment, the ability to use money growth as a policy guide depends on
the stability of the velocity of money.
Two criteria for the use of money growth as a direct monetary policy target:
A stable link between the monetary base and the quantity of money
A predictable relationship between the quantity of money and inflation
These allow policymakers to Predict the impact of changes in the central bank's balance sheet
on the quantity of money
Translate changes in money growth into changes in inflation.
Output and Inflation in the Long Run
Potential Output
Potential output is what the economy is capable of producing when its resources are used at
normal rates.
Potential output is not a fixed level, because the amount of labor and capital in an economy can
grow, and improved technology can increase the efficiency of the production process
Unexpected events can push current output away from potential output, creating an output gap
In the long run, current output equals potential output.
Long-Run Inflation
In the long run, since current output equals potential output, real growth must equal growth in
potential output.
Ignoring changes in velocity, in the long run, inflation equals money growth minus growth in
potential output.
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Money & Banking ­ MGT411
VU
Though central banks focus on controlling short term nominal interest rates, they keep an eye on
money growth
When they try to adjust level of reserves in banking system to maintain interest rate, it affects
money growth. Which in turn determines inflation
Money Growth, Inflation, and Aggregate Demand
Aggregate demand tells us how spending (demand) by households, firms, the government, and
foreigners changes as inflation goes up and down.
The level of aggregate demand is tied to monetary policy through the equation of exchange
(MV=PY) because the amount of money in the economy limits the ability to make payments.
Rearranging the equation of exchange
MV
=
ad
Y
P
Where Yad = aggregate demand,
M = the quantity of money,
V = the velocity of money, and
P = the price level.
From this expression it is clear that an increase in the price level reduces the purchasing power
of money, which means less purchases are made, pushing down aggregate demand
Aggregate   ad
M
ney Growth
Inflation
Demand  Y
P
Velocity
Mo
Unchanged
Unchanged
and less than
inflation
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY