• Principal mechanism through which central banks attempt to influence aggregate economic activity

  • Economic Growth

  • Employment

  • Inflation

11. Demand for Money “Money Market” slide 36

The demand for money is the quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus (при прочих равных условиях).

A portfolio decision is the choice of how (where) to hold idle funds ( simply funds that are not deposited in an interest bearing or investment tracking vehicle, that is, not participating in the economic markets).

What is demand for Money?

Transactions demand

Money held for the purpose of making everyday market purchases.

Precautionary demand

Money held for unexpected market transactions or for emergencies.

Speculative demand

Money held for speculative purposes, for later financial opportunities.

3 Influences on the Demand for Money

As interest rates rise, people tend to hold less money

As the rate of inflation rises, people tend to hold more money

As the level of income rises, people tend to hold more money

12. Tools of the monetary policy, inflation and interest rate.

Money Market, since slide 43

Tools of monetary policy

1. Discount rate: rate of interest the FED charges on loans to banks

By lowering the rate, banks encourage borrowing from the FED and lending to the public, increasing the money supply

2) Open Market Operations: FED’s purchases and sales of government bonds

By purchasing bonds and paying the sellers, the FED increases the money supply

Expansionary Monetary Policy

Increase the money supply by any one or combination of the above tools

Reduce the interest rate to encourage investment

Increase employment & income

Inflation is an increase in the average level of prices, and a price is the rate at which money is exchanged for a good or service.

The inflation rate is the percentage rate of change of a price index over time.

Here is a great illustration of the power of inflation:

In 1970, the New York Times cost 15 cents, the median price of a single-family home was $23,400, and the average wage in manufacturing was $3.36 per hour. In 2008, the Times cost $1.50, the price of a home was $183,300, and the average wage was $19.85 per hour.

• Prices, expressed in money terms, permit comparison of values between different goods

• Must retain its value—the value of money varies inversely with the price level (inflation)

• If money breaks down as a store of value (hyperinflation), economy resorts to barter (прибегает к бартеру)

• Inflation—Persistent rise of prices

• Hyperinflation—Prices rising at a fast and furious pace

• Deflation—Falling prices, usually during severe recessions or depressions

• Inflation reduces the real purchasing power of the currency—can buy fewer goods/services with the same nominal amount of money

• Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending.

• Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output)

• If inflation is 10% and you get a 7% raise, what has happened to your money income? real income? Your money income has increased by 7% but your real income has decreased by 3%

• What is the percent increase from $30,000 to $32,000? Take the difference and divide by the original number $2,000/$30,000 = 6.7%. Inflation is 5%, are you better or worse off? You are better off, because your real income has increased by 1.7% :-)

• How does inflation change society?

• It breeds uncertainty, diminishes buying power, erodes (разрушать) real savings, causes unemployment, alters social traditions, and confuses the price mechanism

Real and Nominal Interest Rates

Economists call the interest rate that the bank pays the Nominal interest rate and the increase in your purchasing power the real interest rate.

i = r + p

This shows the relationship between the nominal interest rate and the rate of inflation, where

r is real interest rate,

i is the nominal interest rate and

p (пи) is the rate of inflation, and remember that p is simply the percentage change of the price level P.

The Fisher Equation illuminates the distinction between the real and nominal rate of interest. It shows that the nominal interest can change for two reasons: because the real interest rate changes or because the inflation rate changes. The quantity theory and the Fisher equation together tell us how money growth affects the nominal interest rate. According to the quantity theory, an increase in the rate of money growth of one percent causes a 1% increase in the rate of inflation.

According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rates.

Here is the exact link between our two familiar equations: The quantity equation in percentage change form and the Fisher equation.

What is the price mechanism?

The adjustment of prices in response to changing market conditions. Some prices will always increase because of the price mechanism