15. Money market. The demand for money and supply, factors that determine them. Equilibrium in the money market.

Money are financial assets that can be used for performing transactions. Money includes currency and checkable deposits. Money pay no interest, for this reason some of people’s wealth can be held in bonds, which pay positive interest rate, i.

Demand for money (Md) – the amount of money people want to hold. The demand for money for the economy as a whole is a sum of all the individual demands for money. Thus, money demand for the economy depends on the overall level of transactions in the economy and on the interest rate. The overall level of transactions is roughly proportional to nominal income: if nominal income increases by 10%, it is reasonable to think that the amount of transactions in the economy also increases by roughly 10%. The relation between the demand for money, nominal income, and the interest rate is as follows:

Md = $Y*L(i)

(-)

The demand for money Md is equal to nominal income, $Y, times a function of the interest rate, i, denoted by L(i). The minus sign under L(i) shows that the interest rate has a negative effect on money demand, i.e. increase in the interest rate decreases the demand for money. Thus, the demand of money depends positively on the level of income and negatively on the interest rate.

Money supply (Ms)

There are two suppliers of money:

1) Central bank, which supplies currency. The CB changes the supply of money through open-market operations, i.e. by buying or selling bonds in the “open-market” for bonds. If it wants to increase the amount of money in the economy, it buys bonds and pays for them by creating money. If it wants to decrease the amount of money in the economy, it sells bonds, and removes from circulation the money it receives in exchange for the bonds.

2) Commercial banks, which supplies checkable deposits. Banks act as financial intermediaries, institutions that receive funds from depositors, and use these funds to buy bonds or stocks, or make loans to other people and firms.

Equilibrium in the money market

Equilibrium in the money market requires that money supply be equal to money demand, that Ms=Md. Then, using Ms=M, and equation for money demand (Md = $Y*L(i)), the equilibrium condition is

Money supply = Money demand

M=$Y*L(i)

This equation tells us that the interest i must be such that, given their income $Y, people are willing to hold an amount of money equal to the existing money supply M.

Characteristics:

-A growth in nominal income increases the level of transactions in the economy, which leads to an increase in demand for money, as a result the interest rate grow. (Money demand curve shifts to the right)

-An increase in the supply of money leads to a decrease in the interest rate. (Money supply curve shifts to the right)

16.Joint balance of real and monetary sectors of the economy (model is-lm).

The IS-LM model characterizes the implications of equilibrium in both the goods and the money market. The IS curve shows the combinations of interest rate and the level of output that are consistent with equilibrium in the goods market. An increase in the interest rate leads to a decline in output. The IS curve is downward sloping.

The LM curve shows the combinations of the interest rate and the level of output consistent with equilibrium in the money market. Given the real money supply, a increase in output leads to an increase in the interest rate. The LM curve is upward sloping.

Any point on the downward-sloping IS curve corresponds to equilibrium in the goods market. Any point on the upward-sloping LM curve corresponds to equilibrium in money market. Only at point A are both equilibrium conditions satisfied. The intersection of the IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in both markets.

IS-LM model is derived from IS and LM equations:

IS relation: Y = C (Y - T) + I (Y, i) + G

The supply of goods is equal to the demand for goods. In other words, the production (Y) equals demand, which is the sum of consumption, investment, and government spending. Consumption is a function of disposable income (income minus taxes).

LM relation: M/P = Y*L(i)

M/P - real money supply

Y – real income

Real money supply equals real money demand.

Shifts of curves in result of fiscal or monetary policies

Fiscal policy:

A fiscal expansion shifts the IS curve to the right, leading to an increase in output and an increase in the interest rate. A fiscal contraction shifts the IS curve to the left, leading to a decrease in output and a decrease in the interest rate.

Monetary policy:

A monetary expansion shifts the LM curve down, leading to an increase in output and a decrease in the interest rate. A monetary contraction shifts the LM curve up, leading to a decrease in output and an increase in the interest rate.