Monetary Policy, Money Demand, and Quantity Theory Analysis
- Analyze the following figure from an optimal monetary macro perspective, including formulas, graphs, and qualitative analysis.
Monetary Policy and Interest Rates
Using monetary policy, the central bank influences the amount of money and, as a result, the interest rate and income. For example, the Central Bank buys bonds in exchange for money, thus increasing the amount of money, or sells bonds in exchange for money paid by purchasers of the bonds, thus reducing the amount of money.
Changing the relative supplies of money and bonds alters the interest rate or yield at which the public is willing to hold assets. When the Central Bank lowers interest rates or buys bonds, it reduces the supply of bonds in the market, thereby raising their price or reducing their yield. Only at a lower interest rate is the public willing to hold a larger fraction of their wealth in money and a smaller fraction in the form of bonds, assuming their asset mix is flexible.
Analyzing Money Demand
The demand for money balances in real terms depends on the opportunity cost of holding money, usually measured by the yield of alternative assets such as government securities, commercial bills, or money market funds. However, there is another possible substitute: instead of choosing to keep their wealth in financial assets, households or companies can also own real assets like stocks of food, housing, or machines.
This substitutability is particularly important when inflation is very high and capital markets do not work very well. In such cases, it is quite possible that the yield from holding real assets is even higher than that of financial assets.
Example: Money Demand Under High Inflation
Indeed, consider the case of an ordinary family deciding between keeping $100,000 in cash or a checking account, or conversely, keeping it in the form of food stored in their pantry. The advantage of this last alternative is that food, instead of money, maintains its real value. Instead of allowing the purchasing power of their money balances to be eroded by inflation, families convert money into goods, thus avoiding the loss. This flight from money is systematic when inflation rates are high.
The Quantity Theory of Money (MV = PT)
Analyze the Quantity Theory of Money (MV = PT, Irving Fisher) to show effects:
Analysis Points for MV=PT
- Through prices.
- Through the money supply.
- Interpret this formulation using differential equations to relate variables: Money (M), Velocity (V, where 1/V = k constant), Price (P), and Total Transactions or Production (T). Plot the relationship for the case of a liquidity trap.
Response:
Therefore, the rate of change in price levels is proportional to the rate of increase in the money supply minus the rate of growth of national income.
