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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.
123
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
124
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