Lecture 20
THE MONEY MARKET

1. The Quantity Theory of Money

• Rate at which money changes hands

• Velocity is the ratio of nominal GDP to the quantity of money:
  V = P Y / M,

  where M = money supply, V = velocity of circulation, P = price level, Y = real GDP

1.2 Equation of exchange

• MV = PY

1.3 Assumptions

• Economy is at full employment:
  Output is determined by factor supplies and technology

• Velocity of circulation is constant

1.3 Predictions of the Quantity Theory

• Higher money supply leads to a proportionate increase in price level

• What would be the appropriate policy to reduce inflation?

1.4 Criticism of the Quantity Theory

• Is velocity constant?
  • Using M1 data: Velocity is very erratic
  • Using M2 data: Velocity stable during 1930-80; has risen since the 80's.

2. Money Demand in the Keynesian Model

• Relationship between interest rate (R) and quantity of money demanded

• Negative slope (why?):
  Think of the opportunity cost of holding money

• Increase in M^d curve due to:
  • Increase in income (Y)
  • Increase in the price level (P)

3. Money Supply

• The M^s curve

• Relationship between interest rates (R) and money supply

• M^s is a vertical line (assumption about the central bank's control of money supply?)

• Increase in money supply causes shift to the right

4. Equilibrium in the money market

• Equilibrium interest rate at intersection of M^d and M^s curves

• Eqbm R is linked to eqbm values of Y and P
  • Higher GDP, ceteris paribus, will cause R to go [ up / down ]. Why?

  • A decrease in the price level, ceteris paribus, will cause interest rates to [ rise / fall ]. Why?