CHAPTER 29
MONETARY THEORY AND POLICY
The Demand and Supply of Money
The distinction between the stock of money and the flow of income
The Demand for Money: Relationship between the interest rate and how much money people want to hold.
People demand money to pay for purchases.
The more active the economy, the more money demanded.
The higher the economy’s price level, the more money demanded.
Money Demand and Interest Rates: The quantity of money demanded varies inversely with the market
interest rate; the opportunity cost of holding money.
The Supply of Money and the Equilibrium Interest Rate
A vertical supply curve implies that the quantity of money supplied is independent of the interest rate.
The equilibrium interest rate is determined by the intersection of the supply of money and the demand for
money.
An increase (decrease) in the money supply decreases (increases) the market interest rate
Money and Aggregate Demand in the Short Run: In the short run, money affects the economy
through changes in the interest rate.
Changes in the supply of money affect the market rate of interest, which affects investment, a component of
aggregate demand.
Interest Rates and Planned Investment
Effect of an increase in the money supply, M
M i I AD Y
–The Fed increases the money supply, M, by buying U.S. government bonds in the open market.
–Interest rate, i, falls.
–Investment spending, I, is stimulated.
–Aggregate demand, AD, increases.
–Real GDP, Y, increases.
Changes in the money supply affect investment if:
–The interest rate is sensitive to changes in the money supply and
–Investment spending is sensitive to changes in the interest rate.
Size of the spending multiplier: Determines the extent to which a given change in investment affects total
spending.
Adding Short-Run Aggregate Supply: For a given shift of the aggregate demand curve, the steeper the short-
run aggregate supply curve:
The smaller the increase in real GDP
The larger the increase in the price level
CaseStudy: Targeting the Federal Funds Rate
Money and Aggregate Demand in the Long Run: An increase in the supply of money increases
aggregate demand which leads to a higher price level since the economy’s potential output is fixed in the long
run.
The Equation of Exchange: M
V = P
Y – Total spending always equals total receipts
M: Quantity of money in the economy.
V: Velocity of money, the average number of times per year each dollar is used to purchase GDP.
V = P
Y / M
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Chapter 30 Monetary Theory and Policy 310
P: The average price level.
Y: Real output, real GDP.
The Quantity Theory of Money: If the velocity of money is stable or at least predictable, then the equation of
exchange can be used to predict the effects of changes in the money supply on nominal GDP.
The quantity theory of money. M
V = P
Y predicts:
–An increase in the money supply results in more spending and a higher nominal GDP (PY).
–An increase in the money supply over the long run (assuming the economy is at potential output) results
only in higher prices.
What Determines the Velocity of Money?
The customs and conventions of commerce
Commercial innovations that (ATMs, debit cards) have facilitated exchange
Frequency with which workers are paid
Stability of money as a store of value (periods of high inflation results in money being a poor store of
value)
How Stable Is Velocity? Since 1980 the velocity of M1 has been variable and by the early 1990s the velocity
of M2 had grown more volatile. In 1993 the Fed announced money aggregates, including M2, would no
longer be considered reliable guides for monetary policy in the short run. Since 1993, the equation of
exchange has been considered a rough guide linking changes in the money supply to inflation in the long run.
CaseStudy: The Money Supply and Inflation Around the World
Use PowerPoint slides 29-32 for the following section
Targets for Monetary Policy
