Chapter 9 Monetary Theory

1. Chapter 9 Monetary Theory

2. Requirement • 1.Grasp • (1)quantity theory of money • (2)liquidity preference theory • (3)modern Quantity Theory of Money • (4)IS-LM model • (5)views of inflation＊ • 2.Main Point • (1)liquidity preference theory • (2)IS-LM model

3. 3.Key Words • Velocity • Transaction motives • precautionary motive • Speculative motive • Liquidity trap • inflation

4. Ⅰ the demand for money 1.Quantity Theory of Money

5. (1)Velocity of money and equation of exchange ----Irving Fisher

7. P is the price level, Y is aggregate output, Velocity V is rate of turnover of money.

8. (2)quantity theory of money • Using k to represent the quantity 1/V (a constant, because V is a constant), we can rewrite the equation as: • Fisher’s quantity theory of money suggests that the demand for money is purely a function of income, and interest rates have no effect on the demand for money • (3) Feature of this theory • The most important feature of this theory is that it suggests that interest rates have no effect on the demand for money.

9. (4)Cambridge approach to money demand • (5)difference between Cambridge and quantity theory of money • Fisher’s emphasize technology factors and rule out any possible effect of interest rates on the demand for money in the short run, whereas the Cambridge approach emphasize individual choice and did not rule out the effects of interest rates.

10. 2.Keynes’ Liquidity Preference Theory

11. (1)brief introduction Development of the theory • This theory is developed by John Maynard Keynesin his 1936 famousbookthe general theory of employment, interest, and Money .

12. John Maynard Keynes (1883-1946)

13. main points There are three motives behind the demand for money: the transactions motive, precautionary motive and speculative motive.

14. (2) Transaction motive • Refers to the demand which individual hold money to carry out everyday transaction. • transactions component of demand is proportional to incomes.

15. (3) precautionary motive • Refers to the demand which people hold money as cushion against an unexpected need • Demand for precautionary money is also proportional to incomes.

16. (4) Speculative motive • Refers to the demand which money is a store of wealth. • speculative component of money demand is related to income and negatively related to the level of interest rates.

17. ⅤPutting the three motives together • demand for money equation: L= L1 (Y)+ L2 (r)=M + － • M: money supply L: money demand Y: income r: interest rate － negatively related + positively related

18. Money supply is determined by central bank, is exogenous variable. Therefore equilibrium interest rate is the intersection point of the demand curve and the supply curve. • See chart on the blackboard

19. (5) Liquidity trap • Liquidity trap refer to a situation where the demand for money becomes infinitely elastic, i.e. where the demand curve is horizontal, so that further injections of money into the economy will not serve to further lower interest rates.

20. policy implications:if the economy enters a liquidity trap area -- and further increases in the money stock will fail to further lower interest rates -- monetary policy will be unable to stimulate the economy.

21. Case study • China’s monetary policy from 1996-2002 • Please see the figure of interest rate and investment of china from 1996-2002 • Please think about why China’s monetary policy did not achieve the goal of stimulating economy? Do you think Keynes’s theory can explain this phenomenon?

23. Summary of the case • The reason of China’s monetary policy inefficacy is as following: • 1. Conduct of monetary policy is clogged. • 2. Demand for money Lack elasticity. • 3. social security system is underdevelopment. • 2. liqudity preference theory can not be used in china, because our interset rate determined by government instead of market..

24. Ⅱ IS-LM Model

25. Introduction of IS-LM model • was developed by Sir John Hicks in 1937 and is based on the analysis in John Maynard Keynes’s influential book The General Theory of Employment, Interest, and Money, published in1936. The ISLM model explains how interest rates and total output produced in the economy (aggregate output or, equivalently, aggregate income) are determined, given a fixed price level.

26. Born:8 April 1904,Warwick, England • Died:20 May 1989 (aged 85)Blockley,England • Nationality:British • Contributions:IS-LM modelCapital theory, consumer theory, general equilibrium theory, welfare theory, induced innovation • Awards:Nobel Memorial Prize in Economic Sciences (1972) John Hicks Neo-Keynesian economics

27. 1. aggregate demand and aggregate supply • National income identity: • C+I+G+NE=C+S+T • I+G+NE=S+T • If do not consider export • I+G=S+T • If there is no government activity • I=S

28. 2. IS curve • (1)definition • The resulting relationship between equilibrium aggregate output and the interest rate is known as the IS curve.

29. (2) Deriving of IS curve • Please see the figure on the blackboard

30. (3)significance of IS Curve • A.The IS curve traces out the points at which the total quantity of goods produced equals the total quantity of goods demanded. • B. If the economy is located in the area to the right of the IS curve, it has an excess supply of goods. • C.If the economy is located in the area to the left of the IS curve, it has an excess demand for goods.. • D. equilibrium in the goods market does not produce a unique equilibrium level of aggregate output.

31. 3.LM curve • (1)definition • LM curve, which describes the combinations of interest rates and aggregate output for which the quantity of money demanded equals the quantity of money supplied.

32. (2)Deriving of LM curve • Please see the blackboard

33. (3)significant of LM curve • A. The LM curve traces out the points that satisfy the equilibrium condition that the quantity of money demanded equals the quantity of money supplied. • B. If the economy is located in the area to the left of the L M curve, there is an excess supply of money. • C.If the economy is located in the area to the right of the LM curve, there is an excess demand for money.

34. 4.IS-LM curve • equilibrium :equilibrium is at the intersection of the IS and LM curves. At this point, aggregate output equals aggregate demand (IS ) and the quantity of money demanded equals the quantity of money supplied (LM ) . • Please see the figure on the blackboard.

35. Discussion: • How can we use monetary policy to change the equilibrium of IS-LM model

36. Ⅲ Money And Inflation

37. 1. Meaning of Inflation • a continuing and rapid rise in the price level .

38. 2.views of inflation • (1)monetarist views • Monetarist analysis indicates that rapid inflation must be driven by high money supply growth. • (2)Keynesian view • The conclusion is the same one that the monetarists reach: A rapidly growing money supply will cause the price level to rise continually at a high rate, thus generating inflation.

39. 3.origin of inflationary monetary policy • (1)high employment target and inflation • cost push inflation • demand pull inflation

40. (2)budget deficit and inflation • Issue money • Monetizing the debt ――printing money

41. Please analyze the reason of inflation of China from 2010-2011.

42. 1.expansionary monetary policy of 2009 • 2.deficit • See Excel.

43. 4. Activist/Nonactivist Policy Debate • (1) the response of government to high unemployment • (2)time lag of monetary policy

44. (3)views of activist and nonactivist • A. view of activist • B .Views of nonactivist

45. (4)expectation and the activist and nonactivist debate • (5)rules versus discretion • Activists： discretionary policy. • Nonactivists :a constant-money-growth-rate

46. discussion Government of china is nonactivist or activist? why do they act as discretion instead of monetarist rule .

47. Summary • 1.the quantity theory of money is a theory of how the nominal value of aggregate income is determined. Because it also tells us how much money is held for a given amount of aggregate income, it is also a theory of the demand for money. The most important feature of this theory is that it suggests that interest rates have no effect on the demand for money. Cambridge approach emphasize individual choice and did not rule out the effects of interest rates.

48. 2. liquidity preference theory thinks that there are three motives behind the demand for money: the transactions motives, the precautionary motives and speculative motive. Nominal demand for money is • L= L1 (Y)+ L2 (r)=M • Money supply is determined by central bank, is exogenous variable. Therefore equilibrium interest rate is the intersection point of the demand line and the supply line. if the economy enters a liquidity trap area -- and further increases in the money stock will fail to further lower interest rates -- monetary policy will be unable to stimulate the economy.

49. 3.IS means investment equals savings, LM means money demand equals money supply, IS-LM model examines an equilibrium in which aggregate output produced equals aggregate demand, and since it assumes a fixed price level, real and nominal quantities are the same.

50. 4. A rapidly growing money supply will cause inflation. The origin of high inflationary policy are : high employment target which induce cost push and demand pull inflation; persist budget deficit which should be financed by issuing money and monetizing debt. activists and nonactivists have a debate on implementation of monetary policy, activists think government should take monetary policy to stimulate economy , but nonactivists think that economy can get equilibrium by itself and government should increase money supply with single rule.