Impact of Money Demand on Economy Dynamics
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ScribdTranslationsImpact of Money Demand on Economy Dynamics
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1. Assume that there is a reduction in aggregate money demand.
real, that is, a negative change in the aggregate demand function of
money in real terms. Indicate the effects of this reduction in the short term and in the long term.
long term on the exchange rate, the interest rate, and the price level.
2. How would you expect a decrease in the population to affect a
country to its function of aggregate money demand? Would it be important that the
the decline in the population was due to a decrease in the number of families
instead of a decrease in the average family size?
3. The velocity of circulation of money, V, is defined as the quotient between the
PNB and money holdings in real terms, V = Y/(M/P), expressed with
the symbols of this chapter. Use Equation (15.4) to deduce a
expression of speed, and explain how speed varies with changes in R
and in Y. (Hint: the effect of variations in V depends on the elasticity of the
aggregate money demand relating to real production, that the
Economists consider the unit to be inferior). What is the relationship between the
speed and the exchange rate?
4. What is the short-term effect on the exchange rate of an increase in
PNB, given the expectations about future exchange rates?
5. Does our analysis of the usefulness of money as a medium of exchange suggest
as a unit of account any reason why some currencies are
Do they convert into vehicle currencies for currency transactions? (The
the concept of vehicle currency was analyzed in Chapter 14.
6. If a monetary reform does not affect the real economic variables of a
country, why do governments carry out monetary reforms within
broader action programs aimed at stopping inflation
galloping? (There are many other cases different from the one in Turkey mentioned in
the text. Recent examples include: the change in Israel from the pound to
shekel, the one from Argentina from the peso to the austral and back to the peso, and that of Brazil
from the cross to the crusader, back again to the cross, from the cross to the cross
real and from the real cross to the real, the current currency introduced in 1994.
7. Suppose that the central bank of a country with unemployment doubles its supply.
monetary. In the long term, full employment and the level will be reached again.
production will return to its full employment level. Given the assumption that the rate
the interest prior to the increase in the money supply coincides with the rate of
long-term interest, will prices experience an increase more than
proportional or less than proportional to that of the money supply? What
it happens if (most likely) the interest rate was initially below
your long-term level?
Between 1984 and 1985, the money supply in the United States increased from
570.300 to 641.000 million dollars, while in Brazil it increased from
24.400 million cruzados to 106.100 million cruzados. During the
same period of time, the consumer price index of goods in
The United States went from 96.6 to 100, while the corresponding index
for Brazil went from 31 to 100. Calculate the respective growth rates of
the money supply and inflation in the United States and Brazil. Assuming that
the other factors that affect the money supply do not vary differently
important, how do these figures fit with the model predictions of
this chapter? How would you explain the different responses of the price level
of the United States compared to Brazil?
9. Following up on the previous question, we emphasize that the nominal value of the
U.S. production in 1985 was 4.01 trillion.
dollars and 1,418 billion cruzados in Brazil. Doing it again
Reference to Problem 3, calculate the velocity of money circulation d
10. In our analysis of the short-term exchange rate overreaction,
we have assumed that the level of actual production is given. Assume, without
embargo, that an increase in the money supply raises real production
in the short term (assuming it will be justified in Chapter 17). How does it affect
this increase to the degree of overreaction when the money supply
expand first? Is it likely that the exchange rate will underreact? (Hint:
in Figure 15.12a, make the function of real aggregate money demand
It adjusts in response to an increase in production.
11. Figure 14.2 shows that short-term interest rates in Japan
they have periods in which they approach or are equal to zero. The fact that
the interest rates in yen never drop below zero, is it a coincidence, or
Can you think of any reason why interest rates might be possible?
Are they bounded from below at zero?
12. How could a zero interest rate complicate the task of politics?
monetary? (Hint: at a zero interest rate, there is no advantage in exchanging money)
for bonuses).
13. As we have pointed out in this chapter, central banks set a level
the objective of a short-term interest rate, instead of defining it in a way
intended the level of the money supply, being willing to lend or
borrow the amount of money that individuals want to have at that rate
of interest. (When individuals need more money for some reason
different from that of the interest rate variation increases the money supply, and it
(contracts when they want less money).
a) Describe the problems that may arise if a central bank defines its
monetary policy
keeping the market interest rate constant. (First analyze the case
of flexible prices and consider if you can calculate a price level of
unique equilibrium when the central bank is limited to giving individuals everything the
money they want to have at that fixed interest rate. Then analyze the case with
rigid prices)
b) Does this situation change if the central bank raises interest rates when
the prices son elevated, following a formula how
R = a(P, P0), where a is a positive constant and P0 is the level of
target prices?
c) Suppose that the central bank's policy rule is
R R0 a(P P0) u, where u
It is a random movement of interest rate policy. In the model of
overreaction shown in Figure 15.12 describe how it would be adjusted
economy to an unexpected unique fall of the random factor u, and why. It can
interpret the decrease of u as a reduction of the interest rate by
by the central bank and, therefore, as a monetary expansion action.
Compare your analysis with the one shown in Figure 15.13.
Common questions
Powered by AIAn unexpected fall in 'u', representing an unpredicted reduction in interest rates, triggers a monetary expansion as it effectively lowers borrowing costs. This eases financial conditions, leading to increased economic activity and potentially boosting real production in the short term. However, this expansion might also result in an excessive initial increase in demand, which, if accompanied by lagging supply responses, can cause short-term inflationary pressures and exchange rate volatility. These dynamics demonstrate the sensitivity of economies to policy shocks and their complex adjustment paths .
Interest rates in Japan might be bounded at zero or above due to the presence of a zero lower bound, where rates cannot feasibly fall below zero due to the preference for cash over negative-yield investments. Structural explanations include institutional and regulatory frameworks that prevent negative rates or the strategic decision by the central bank to avoid negative perception and maintain financial stability. Psychological and behavioral factors might also play a role, as negative rates could deter investment and destabilize consumer expectations .
Between 1984 and 1985, the money supply increased by approximately 12.4% in the United States and 334.4% in Brazil. During the same period, the consumer price index increased by about 3.5% in the U.S. and 222.6% in Brazil. These figures indicate a much higher elastic response of inflation to money supply changes in Brazil compared to the U.S., consistent with the chapter's prediction that economies with different elasticities of money demand will experience varied inflationary effects. In economies like Brazil, with less controlled monetary environments and higher baseline inflation, increases in money supply directly translated to sharper price level increases .
Setting a constant market interest rate can lead to imbalances if the price levels are flexible. With flexible prices, the central bank's constant rate might not adjust adequately to changes in economic conditions, leading to mismatches between money supply and demand, which results in either an inflationary or deflationary environment. On the other hand, rigid prices can mask underlying imbalances temporarily, but once adjustments occur, they might exacerbate economic fluctuations. This inability to achieve a unique equilibrium price level highlights the risks of such a policy approach .
An increase in real production when money supply expands can moderate the overreaction of exchange rates by increasing the demand for money, thereby reducing the inflationary impact and possibly stabilizing prices. As the economy produces more goods, the increased supply can absorb excess money supply, preventing excessive currency depreciation. Consequently, this can result in underreacting exchange rates as the real production increment has an offsetting effect on monetary expansion's usual depreciating tendency .
A decrease in population size generally reduces aggregate money demand as fewer individuals lead to reduced transaction needs and economic activity. The cause of population decline matters because a reduction in the number of families might lead to lower consumption and money demand initially, while a decrease in family size could maintain some level of consumption per family, stabilizing money demand more than expected. This highlights the nuanced effects of demographic changes on economic indicators .
Zero interest rates pose challenges for monetary policy because they limit the central bank's ability to stimulate the economy through traditional interest rate cuts. With no interest advantage to holding money, the liquidity trap can lead to decreased effectiveness of monetary policy as individuals prefer holding cash over investments, which undermines the central bank's goal to motivate spending and investment. This stagnation prevents the economy from recovering quickly from downturns and complicates efforts to achieve targeted inflation rates .
Monetary reforms that aim to curb hyperinflation primarily target nominal variables, such as stabilizing the currency, to restore confidence and provide an anchor for price expectations. If real economic variables remain unchanged, the reform might still succeed by lowering inflation expectations, which could, in turn, stabilize prices indirectly by improving economic conditions through restored investor and consumer confidence. Historical examples, such as reforms in Israel, Argentina, and Brazil, illustrate how nominal adjustments helped achieve price order despite no immediate real economic changes .
In the short term, a reduction in aggregate money demand typically leads to increased interest rates as the central bank aims to counteract the decreased demand for money. As a result, the domestic currency may appreciate due to higher interest rate levels attracting foreign capital, altering the exchange rate. Price levels might initially remain stable as the economy adjusts to the new demand levels. In the long term, as the economy stabilizes, price levels may decline due to sustained lower levels of aggregate demand, while exchange rates and interest rates may return to a new equilibrium reflecting the overall economic conditions .
The velocity of money circulation, defined as V = Y/(M/P), where Y is the nominal income and M/P represents real money balances, is influenced by changes in real production (Y). An increase in real production can lead to an increase in money velocity if money supply does not increase proportionately, reflecting higher economic activity per unit of money. This can affect exchange rates by prompting currency appreciation if increased velocity reflects economic growth, as foreign investors might see the currency as more attractive due to improved economic fundamentals .