Lecture 17: Money and the Price Level II L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.10 4 March 2010

Introduction Last time: – Constructed a realistic model of money demand – Setup the equilibrium between demand and supply – Increases in money supply change nominal variables, but leave real variables unchanged Today – Consider changes in money demand – Explain empirical pattern of prices and GDP

Money Supply Shifts Shifts in money supply changed the price level by shifting supply schedule out/in – Raised the price level – But also raised all nominal variables (prices, wage, rental cost) so real variables unchanged – Now consider factors which shift money demand

Money Demand: Innovation Money demand determined by balance of costs – Cost of holding money: interest foregone – Cost of not holding money: having to more regularly transact bonds to access cash – So financial innovation (transactions technology) lowers the cost of holding money – E.g. ATMs, debit cards, electronic transfer all reduce the cost of not holding money

Money Demand: Innovation If innovation lowers cost of not holding money, households choose to hold less money – Off-load their unnecessary money by purchases of goods and bonds – Increases nominal demand for goods and bonds, so increases nominal prices – One-off increase in the price level – All real variables unchanged

Money Demand: i and Y Money demand also changes when interest rates and overall output changes Impact on money demand of positive shock to A, would be: – Higher i decreases money demand as interest foregone increases – Higher Y increases money demand as household need more cash to service transactions

Which effect is bigger? Overall effect on demand depends on relative strength of the two effects – Sensitivity of money demand function L(i,Y) to changes in i and Y – Empirical evidence suggests that the effect of i changes on demand is less than effect of Y changes – So expect that demand increases as Y increases, so prices are countercyclical

Price-Level Targeting In principle, introducing money causes no problems in the economy because individuals care about real values – In practice, policymakers worry than inflation is costly because it causes price uncertainty – Households find it difficult to plan for the future (write nominal contracts) when prices vary – So policymakers try to stabilise prices

Endogenous Money How can they do this: money supply – Whenever money demand rises / falls, government can respond by changing money supply so that prices remain the same – Call this process ‘endogenous money creation’ – Reaction to money demand, hence money supply is endogenous in the model

Targeting the Price-Level Equilibrium in the money market Can offset effect of increases in Y,i on P by altering M. Target level of P is P-bar

How to Price-Target Long-term technological progress implies Y is growing over time – If Y is growing over time, demand for money is also growing, so price level falling over time – To maintain stable prices, need to increase M to offset the effect

How to Price-Target Short-term fluctuations implies Y fluctuations need to be matched by M fluctuations – Over business-cycle, Y rises and falls – Need to stabilise P by altering money supply in ling with changes in Y – Y rises: expand money supply – Y falls: reduce money supply – Known as ‘cyclical money management’

Summary From money demand function, expect prices to be counter-cyclical – Evidence suggests this is the case – In recessions, households hold more cash and so price level falls – Price-targeting can reduce price uncertainty Next time: consider inflation – So far considered static scenario, next consider dynamics and implications for inflation