Money Demand and IS Curve

Question 1

What is the Quantity Theory of Money? What can the Quantity Theory suggest?

Answer 1

• MV = PY
• Money supply has a casual proportional level with PL
• Assume v is a constant: Meaning M = (1/vbar) x PY
• k is a parameter (1/vbar), meaning M = kPY- showing proportionality
• In the LR, Y is not affected by M, but instead technology improvements
• In the SR, ΔM = ΔP + ΔY - ΔVbar => Can tell the growth of M
• If ΔVbar = 0 and ΔY is exogenous, we can set ΔM to the equal target of ΔP

Question 2

How can money demand show that real money balances are not dependant on interest rates?

Answer 2

• If we say M = MD; then:
  MD/P = Y/Vbar
• MD/P are the demand for real money balances- unreliant on interest rates
• MD is a function of income

Question 3

What is the correlation between ΔP and ΔM?

Answer 3

• 0.79 in the US
• 0.74 globally

Question 4

What are the reasons why people would hold cash?

Answer 4

• Transactions: Both MD and Transactions are broadly proportional to income => Link between MD and Y
• Precautionary: People hold money as a cushion against unexpected wants
• Speculative: People hold money as assets- opportunity costs are returns on other assets => Hold less M as i rises

Question 5

Is V a constant? Why/Not?

Answer 5

• Combining the three rules, we know that:
  MD / P = L(i,Y)
• PY/MD = Y / L(i,Y) = V
• This shows that V is procyclical, not a constant- and procyclicality of i should induce the same of V

Question 6

What is portfolio theory?

Answer 6

• Other factors affecting your demand impact other asset, such as wealth, risk, liquidity
• MD/P is +vely related to Y and -vely related to i

Question 7

What are the factors that impact the demand for real money balances? How do they affect the demand?

Answer 7

• Interest Rate: Increasing this DECREASES MD due to the rising opportunity costs
• Income: Increasing this INCREASES MD due to higher transactional value
• Payment technology: Increasing this DECREASES MD due to the reduced need for money for transactions
• Wealth: Increasing this INCREASES MD due to the increased ability to have MD
• Riskiness of other assets: Increasing this INCREASES MD due to money becoming relatively less risky
• Inflation risk: Increasing this DECREASES MD due to money becoming relatively more risky
• Liquidity of other assets: Increasing this DECREASES MD due to money becoming relatively less liquid

Question 8

What is the link between the nominal interest rate and money stability?

Answer 8

• Must consider the sensitivity of M to changes in i
• If no, V is predictable
• If yes, V is unpredictable- QToM fails
• If unstable, the link between M and PY breaks, meaning that Monetary policy could be unstable or ineffective
• FFR Target is preferred to M level as it is a better signal

Question 9

How is each componant of the IS curve formula related to Y or i?

Answer 9

• We know that if savings = investment; I = Y - T - C + (T - G)
• C = CBar + MPC (DI or Y - T)
• I = Ibar + d(ri), where Ibar is fixed investment, I is inventory investment and d is a responsiveness function
• ri = r x f, where f are financial frictions. Credit spread
• Treat G and T as exogenous
• NX = NXbar - xε, where x is a responsiveness function and ε is the RER

Question 10

What is the goods market equilibrium? What are shift/slope factors in this equation?

Answer 10

• Y = [Cbar + Ibar + Gbar - dfbar + NXbar - MPCTbar -xε] x 1/(1-MPC) - dr/(1-MPC)
• SHIFT: Cbar, Ibar, Gbar, fbar, NXbar, Tbar
• SLOPE: d, MPC

Question 11

Why is the IS curve used?

Answer 11

• IS Curve tells us the points where the goods market is in equilibrium
• Assumes fixed price level
• Aggregate Output = Aggregate Demand
• Anything ABOVE IS curve gives excess supply
• Anything BELOW IS curve gives excess demand
• Move back to equilibrium due to rises/falls in Y

Question 12

What are the effects that the shift factors have on the IS curve?

Answer 12

• Cbar: Increasing this increases Y, shifting IS Curve out
• Ibar: Increasing this increases Y, shifting IS Curve out
• Gbar: Increasing this increases Y, shifting IS Curve out
• fbar: Increasing this decreasing Y, shifting IS Curve inwards
• Gbar: Increasing this increases Y, shifting IS Curve out
• Tbar: Increasing this decreasing Y, shifting IS Curve inwards

Question 13

How can you derive the MP curve?

Answer 13

• This can be done via the Taylor Rule
• r = r * + 0.5(π - π * ) + 0.5(Y - Y * )
• Central bank responds to monetary policy as a response to π and Y
• Increased π will cause C.B to choose a higher IR at any given Y
• Increased Y will cause C.B to raise r
• THIS MEANS THAT r(π, Y) is an increasing function

Question 14

What do MP and IS curves look like? What policies impact each curve?

Answer 14

• IS Curve is downward sloping
• MP Curve is upward sloping
• Fiscal Policy shifts IS curve
• Monetary Policy shift MP curve
• Anything expansionary shifts curves outwards

Question 15

How do C.Bs control real interest rates?

Answer 15

• If M/P = L(i,Y), using the fisher equation , we can say that M/P = L(r + Eπ, Y)
• Central Banks control nominal money supply directly
• But, this doesn’t necessarily impact change M/P
• This is dependant on whether prices are sticky or flexible

Question 16

How does money supply change when prices are sticky?

Answer 16

• Assuming is P = Pbar
• This means that if M1>M0, this will take the economy away from equilibrium- r falls and Y rises => Movement down IS Curve
• However, in practice, not all changes immediately filter through- reality is that prices are more sluggish than fixed

Question 17

How does money supply change when prices are flexible?

Answer 17

• There is a slower increase from M0 to M1, however, this is still in disequilibrium, once again moving down the IS Curve
• UNLESS Prices are completely flexible; in which case M0/P0 = M1/P1
• But, this would mean that C.Bs cannot impact r => which crucially underpins much of this theory