week 6 Flashcards by grace bailey

quantity theory of money

MV=PY
stability of Velocity
stability of Y income

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interest rate transmission mechanism

1- money supply changes- interest rate link
2- interest rate- investment link
3- aggregate demand changes as a result so does multiplier effect

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monetary transmission mechanisms (IR)

money supply increase
interest rate decrease
investment increase
saving decrease
aggregate demand increase
GDP (Y) increase
price (P) increase

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effect of rise in money supply

increase money supply= lower interest = higher investment willing

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withdrawals = injections

= aggregate demand on interest rate transmission mechanism

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investment increase

means injections increase in equation. causes equilibrium to increase

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limitations of interest rate transmission (stage 1 money- interest rate link)

elastic demand for money
unstable demand for money

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liquidity trap

a situation where monetary policy becomes ineffective because interest rates are near zero, and people prefer to hold cash rather than invest or spend, even with low borrowing costs

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effect of fluctuating demand

with a fixed money supply, fluctuations in demand can lead to fluctuations in interest rates. increase interest rate = more demand

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limitations of interest rate transmission (stage 2 interest rate - investment link)

inelastic investment demand
unstable investment demand

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different views on demand for investment

inelastic- changes in investment small resulting in small change in AD

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effects of unstable investment demand curve

fall in interest rates (increased confidence) small increase in investment levels Q0-Q1. l2 means Q0-Q2 more effective

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effects of unstable investment demand curve

fall in interest rates (decrease confidence) causes small increase in investment Q0-Q1 but money supply fall causing Q0-Q3 investment to decrease

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consider balance sheets

pre cautionary effects
cash flow effects

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cash flow effects

as household, if you have short term debts, and interest rates are lowered, you pay less interest meaning consumption may rise

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precautionary effects (precautionary saving)

decrease interest rates as as signal of a recession
people start saving
increase hurdle rate of interest
investment may decrease

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summary interest rates falling

savings go down and investment goes up

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hurdle rate of interest

minimum return on an investment that is needed to make the investment. if anticipate recession, require higher return on any potential investment in order to make the investment

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exchange rate transmission mechanism stages

money supply- interest rate link
interest rate - exchange rate link
exchange rate - import and export link

monetary transmission mechanism

demand for foreign assets increase as money supply increases. exchange rate falls (pound depreciates) as less demand for pound. foreign goods more expensive so imports fall and export increase. aggregate demand increases

exchange rates affecting imports and exports

pound weaker, exports higher

interest rates effecting exchange

interest rates determined in money market.
interest rates affect demand and supply in foreign exchange market

exchange rates affect equilibrium

exports are an injection. imports are a withdrawal. exports increase = injections increase. withdrawals go down as fewer imports

effect of an increase in money supply

demand for foreign assets increase, supply of pound increase. demand for pound falls. more exports, less imports = trade surplus

summary exchange rate transmission mechanism

lower interest rates = demand foreign currency

theory of portfolio balance

mechanism stressed by monetarists. Keynesian critique

money supply increase

supply > demand =surplus liquidity =used to buy goods/services which will eventually increase aggregate demand

monetary growth in UK

excess nominal money balances as an indicator of short term activity and price movement. growth rate of money holdings of sub-sectors

short run variability of velocity

depends on whether money supply is directly controlled e.g. the use of quantitative easing in response to the aftermath of the financial crisis and the Covid-19 pandemic

crowding out

public sector goes up, private investment sector goes down

extent of crowding out

responsiveness of demand for money to an interest rate change responsiveness of investment to an interest rate change

different views on demand for money (elasticity)

Keynesian believe liquidity preference curve is elastic new classical/ monetarists believe curve is inelastic

different views on demand for money (interest rates)

Keynesian believe change in demand for money has small effect on interest rate new classical/ monetarists believe change in demand for money had large effect on interest rate

different views on demand for money (investment curve)

Keynesian believe interest investment curve relatively inelastic new classical/ monetarists believe interest investment curve elastic

money supply exogenous or endogenous

Keynesians- total endogenous (affected by aggregate demand) monetarists- total exogenous (crowding out takes place) need to reduce endogenous element if government

contemporary analysis applies the IS/MP model

equilibrium in goods market interest rates are key tool of monetary policy In many countries inflation rate target

elasticity of IS curve

-more responsive I and S- larger effects on national income = elastic IS -size of multiplier (1/mpw) -Keynesians; inelastic IS - interest rates don't affect goods market much -monetarists; elastic IS - interest rates significantly affect saving & investment

the IS curve

real interest rate, national income and equilibrium in goods market every point on curve withdrawals = injections

MP curve

national income and real interest rate chosen by monetary authorities deriving mp curve -inflation targeting by central banks -price expectations inertia

deriving MP curve

rise in national income leads to higher rate of inflation and hence central bank raising interest rates to bring inflation back towards the target

mp curve shifts

change in national income Y; shift to right inflationary shock; MP shifts upward change in target rate of inflation; MP shifts downwards

evidence of credit cycles

financial accelerator - interest rate differentials -availability of credit -interaction of multiplier and financial accelerator -financial accelerator and the IS/MP framework

financial instability hypothesis

-stages of credit accumulation (financial tranquility, fragility and bust) -irrational exuberance (euphoria - confidence - increase exp returns on assets) -minsky moment (economic shock after irrational exuberance) -balance sheet recession

IS/LM model analysis

no inflation target central bankdirectly influence money supply

the IS curve

movement along versus shifts of IS curve

the LM curve

deriving the LM curve

money market equilibrium