12.3 How Money Affects Aggregate Demand

Question 1

What is monetary equilibrium?

Answer 1

monetary equilibrium—the theory of how interest rates are determined in the short run by the interaction of money demand and money supply.

Question 2

What is the Monetary transmission mechanism?

Answer 2

The channels by which a change in the demand for or supply of money leads to a shift of the aggregate demand curve.

Monetary transmission mechanism—the chain of events that takes us from changes in the interest rate, through to changes in desired aggregate expenditure, to changes in real GDP and the price level.

Question 3

Graph of Monetary equilibrium

Answer 3

Question 4

Why is the money supply curve vertical?

Answer 4

The money supply curve is vertical, indicating that it is assumed to be independent of the interest rate.

Question 5

What causes the money supply to increase or decrease (Shift right or left) ?

Answer 5

The money supply increases ( shifts to the right) if the central bank increases reserves in the banking system or if the commercial banks decide to lend out a larger fraction of those reserves.

The money supply decreases ( shifts to the left) if the central bank decreases reserves in the banking system or if the commercial banks decide to reduce their lending.

Question 6

Why is the money demand curve downward sloping?

Answer 6

The money demand curve is downward sloping, indicating that firms and households decide to hold more money (and fewer bonds) when the interest rate falls.

Question 7

When does the interest rate rise and fall?

Answer 7

The interest rate rises when there is an excess demand for money and falls when there is an excess supply of money.

Question 8

What is Monetary equilibrium?

Answer 8

Monetary equilibrium

The situation in which the quantity of money demanded equals the quantity of money supplied.

Question 9

What does interest rate represent in the money market?

Answer 9

In the money market, the interest rate is the “price” that adjusts to bring about equilibrium.

Question 10

What can a single household or firm do when they would like to hold more or less money?

Answer 10

When a single household or firm finds that it would like to hold more money (and fewer bonds) it can sell some bonds and add the cash proceeds to its money holdings. If the preference instead is to hold less money, the household or firm can buy bonds. Such adjustments in money and bond holdings for an individual household or firm can easily be made and will have a negligible effect on the economy.

Question 11

Consider a disequilibrium situation in which firms and households would like to adjust their portfolios by holding more money and fewer bonds.

Answer 11

Question 12

Consider a disequilibrium in which firms and households would like to adjust their portfolios by holding less money and more bonds.

Answer 12

Question 13

When does Monetary equilibrium occur?

Answer 13

Monetary equilibrium occurs when the interest rate is such that the quantity of money demanded equals the quantity of money supplied.

Question 14

What is the liquidity preference theory or interest? What is portfolio balance?

Answer 14

The theory of interest-rate determination depicted in Figure 12-2 is often called the liquidity preference theory of interest.

This name reflects the fact that when there are only two financial assets, a demand to hold money (rather than bonds) is a demand for the more liquid of the two assets—a preference for liquidity.

The theory determines how the interest rate fluctuates in the short term as people seek to achieve portfolio balance, given fixed supplies of both money and bonds.

Question 15

What are the three stages of the monetary transmission mechanism?

Answer 15

Question 16

What do changes in either the supply of money or the demand for money do to the equilibrium interest rate?

Answer 16

Changes in the supply of money or in the demand for money cause the equilibrium interest rate to change.

Question 17

An increase in money supply from an increase in money reserves leads to…

Answer 17

Question 18

An increase in money supply leads to…

Question 19

An increase in money supply with an unchanged supply of money leads to…

Answer 19

Question 20

Changes in either the demand for or the supply of money cause…

Answer 20

Changes in either the demand for or the supply of money cause changes in the short-run equilibrium interest rate.

Question 21

What does an increase in money supply do to the equilibrium intrest rate and desired investment expenditure?

Answer 21

Increases in the money supply reduce the equilibrium interest rate and increase desired investment expenditure.

Question 22

What do changes in the money supply do to the AE and AD functions?

Answer 22

Changes in the money supply cause shifts in the AE and AD functions.

Question 23

What does an increase or a decrease in the money supply do to the interest rate and desired aggregate expenditure?

Answer 23

An increase in the money supply causes a reduction in the interest rate and an increase in desired aggregate expenditure; it therefore causes a rightward shift of the AD curve.

A decrease in the money supply causes an increase in the interest rate and a decrease in desired aggregate expenditure; it therefore causes a leftward shift of the AD curve.

Question 24

Summery of moneitary transmission mechinism.

Answer 24

Question 25

How can we compare bonds from ours and simular coutries (Canada and US) and bonds from other countries?

Answer 25

Bondholders, either in Canada or abroad, are able to substitute among Canadian bonds, U.S. bonds, German bonds, and bonds from almost any country you can think of.

Bonds from different countries are generally not perfect substitutes for each other because the varying amounts of political and economic instability imply that different levels of risk are associated with different bonds. But bonds from similar countries—Canada and the United States, for example—are often viewed as very close substitutes.

Question 26

What does the ability of bondholders to substitute easily between bonds from different countries imply?

Answer 26

The ability of bondholders to substitute easily between bonds from different countries implies that monetary disturbances that cause changes in interest rates often lead to international flows of financial capital, which in turn cause changes in exchange rates and then changes in exports and imports.

Question 27

How does an increase in Canadian money supply result in an open economy?

Answer 27

An increase in the Canadian money supply reduces Canadian interest rates and leads to an outflow of financial capital. This capital outflow causes the Canadian dollar to depreciate.

Question 28

What is the overall effect of an increase in the Canadian money supply on an international level?

Answer 28

So the overall effect of the increase in the Canadian money supply is not just a fall in Canadian interest rates and an increase in investment.

Because of the international mobility of financial capital, the low Canadian interest rates also lead to a capital outflow, a depreciation of the Canadian dollar, and an increase in Canadian net exports.

This increase in net exports strengthens the positive impact on aggregate demand already coming from the increase in desired investment.

Question 29

The Open-Economy Monetary Transmission Mechanism

Answer 29

Question 30

In an open economy with capital mobility, an increase in the money supply causes…

Answer 30

In an open economy with capital mobility, an increase in the money supply causes an increase in aggregate demand for two reasons.

First, the reduction in interest rates causes an increase in investment.

Second, the lower interest rate causes a capital outflow, a currency depreciation, and a rise in net exports.

Question 31

What were the two reasons we have previously learned as to thy the AD curve is negativly sloped?

Answer 31

a change in the price level causes a change in wealth and also causes a substitution between domestic and foreign goods.

Question 32

What is the theird reason for why the AD curve is negativly sloped?

Answer 32

A rise in the price level raises the money value of transactions and thus leads to an increase in the demand for money.

For a given supply of money (a vertical curve), the increase in money demand means that the curve shifts to the right, raising the equilibrium interest rate.

The higher interest rate then leads to a reduction in desired investment expenditure (and, in an open economy, to a reduction of net exports).

Question 33

To summarize, in our more complete macro model, the AD curve is downward sloping for three reasons.

Answer 33

As the domestic price level changes:

Domestic wealth changes

Substitution of expenditure occurs between domestic and foreign products

The interest rate changes, which leads to changes in investment and net exports

Question 34

What direction do the three effects of why AD curve is negativly sloped move in with a rise and fall in price level?

Answer 34

As the price level falls, all three effects work in the same direction, increasing desired aggregate expenditure.

As the price level rises, the three effects work in the same direction, decreasing desired aggregate expenditure.