Money and Real Economy Money, Bonds, Monetary Policy, GDP 1

 Money and Bonds  There are many things in the economy  Cash  Chequing accounts  Saving accounts  Treasury bills  Bonds  Business shares (equity)  etc  Simplify  Yields no interest = money  Medium of exchange  Cash  Chequing accounts  Yields interest = bond  Medium of saving 2

 Discounting  A bond  Coupon  Maturity T  Price  Yield i  Present value of a bond  Stream of revenues in the future  Discounted future payments  Present value of a stream  In equilibrium, bonds yield market interest rate  The equilibrium market price of a bond = PV of the income stream 3

 Demand for money  Demand for money = amount of money that everyone in the economy wants to hold  Greater demand for money = lower demand for bonds  Reasons to hold money  Transaction demand  Simplest, M = aY  Precautionary demand  Speculative demand  Adjusting portfolio of financial assets  Lower interest rate expected = we expect bond prices will increase = we want more bonds now = we want to hold less money now 4

 Demand for money, curve  Interest rate is negatively related to the amount of money we want to hold  Interest rate = cost of holding money  M D = M D (i, Y, P)  ∂M D /∂I < 0  Along the M D curve  ∂M D /∂Y > 0  Shift in the M D curve  ∂M D /∂P > 0  Shift in the M D curve 5

 Monetary equilibrium  Money supply M S is independent of interest rate  Print more money = greater money supply  Let banks create more money = greater money supply  Any of these increase reserves  Monetary equilibrium: M D = M S  Because the bond prices change and so the interest rate changes  This is the liquidity preference theory of interest 6

 Monetary Transmission Mechanism  Step 1:  The liquidity preference theory of interest:  Increase in M S  Decrease in equilibrium interest rate  Increase in equilibrium quantity of money  Increase in M D  Increase in equilibrium interest rate  No change in equilibrium quantity of money 7

 Monetary Transmission Mechanism  Step 2:  Decrease in equilibrium interest rate  Increase in desired investments  Demand for investments  Increase in consumption  Big ticket items  Increase in net exports  Capital outflow  Depreciation of Canadian dollar  Domestic goods cheaper than foreign goods  The slope of the AD curve 8

 Long Run vs Short Run  Short run:  Increase in money supply =>  Increase in AD =>  Positive AD shock  Long run  Y* = const  Recall, factor prices will adjust  Now can think:  Positive AD shock => P increases => M D increases => interest rate increases 9

 Long Run vs Short Run  We say  Money are neutral in long run  Means money do not influence real GDP in long run  Money are not neutral in short run  Means money do influence real GDP in short run  This is Classical Dichotomy 10

 Effectiveness of monetary policy  M D steep  I D flat  Monetary policy is effective  Monetarists  M D flat  I D steep  Monetary policy is ineffective  Keynesians 11