Skip to main content

Macroeconomics: the money market and loanable funds market

 

The money market:

  • The money market combines the supply of money and the demand for money for a country.
    • The supply curve (Sm) is inelastic and is determined by the central bank.
    • The demand curve (Dm) is the horizontal summation of the asset and transaction demand curves and is sloping downward.
    • The intersection between the Sm and Dm is the equilibrium interest rate for a country.

  • A change in the nominal interest rate implies that either or both curves (i.e Sm and Dm) have shifted to the right or left.
    • An increase in nominal GDP (P*Y) will lead to an increase in the transaction demand for money which will shift the total demand (Dm) to the right. The nominal interest rate goes up.

    • A decrease in the level of output (Y) will shift the Dm curve to the left.
  • The Sm curve will shift whenever the central bank decides to change the money supply due to a monetary policy decision.
    • The Fed expands the supply of excess reserves in commercial banks, by purchasing bonds from banks, Sm shifts to the right. The nominal interest rate (i) goes down.

    • When the Fed reduces the excess reserves by selling government bonds to commercial banks (i.e reducing the level of liquidity in the system) the Sm shifts to the left, the nominal interest rate at equilibrium goes up.
Loanable funds market:
  • Investment demand is inversely related to the real interest rate (r)
    • assuming that the expected inflation does not change, then an increase in the nominal interest rate (i) will increase the real interest rate(r). 
    • Assuming i stays constant if inflation (denoted by pi) is expected to increase, the r goes down.

  • A change in either inflation or nominal interest rate will cause a movement along the demand curve for investment (changing the quantity of funds demanded for investment). 
  • If a monetary policy reduces the supply of money, this will lead to a reduction of funds demanded for investment which will shift the aggregate demand curve to the left in the AD/AS model which causes a reduction in real output (Y) and a downward pressure on the price level (i.e deflation). This is known as a contractionary monetary policy. 
  • An expansionary monetary policy is one which increases the money supply which causes an increase in the quantity of funds for investments, causing the AD curve to shift to the right, increasing Y and putting upward pressure on the price level (i.e inflation). 
Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 162-167.

    Labels:
    Location: Boston, MA, USA

    Comments

    Post a Comment

    Popular posts from this blog

    Econometrics: Bivariate population model

    Hello I'm finally back from my extended break. I thought that we should start studying Econometrics.  Let's begin by analyzing a simple bivariate regression. Assume that this equation describes the relationship between two variables X and Y. We say that Y is the dependent variable, whereas X is the independent variable. In other words, we assume that Y (the output) depends on X (the input). Epsilon is the error term, it represents other factors that affect Y. The error term must be uncorrelated with the variable X so that we do not need to include them in our regression, and thus the coefficient of X (beta) should not change, even though Epsilon also determines Y.  beta-0 is the constant term. It tells us what would be Y if X=0. beta-1 is the effect on Y if X changes by one unit. To see this, assume X=education is a continuous function, let's take the derivative of Y=wage with respect to X: Thus, if education goes up by one unit, we should expect, on average, wage to go up
    Post a Comment
    Read more

    Macroeconomics: multiplier and crowding out effects

    Multiplier effect: whenever   any of the components of AD increases, the increase in GDP will be greater than the initial increase in expenditures. The impact on GDP of a particular increase in spending depends on the proportion of the new income that is taken out of the system to the proportion that continues to circulate in the economy. The multiplier effect tells us the impact a particular change in one the components of AD will have on the total income (GDP).  Let k denote the spending multiplier, which is a function of MPC and MPS. The larger the marginal propensity to consume, the larger the spending multiplier. Notice that the larger the MPC, the greater the impact a particular change in the spending variables will have on the nation's GDP. The crowding out effect: If government spending increases without an increase in taxes, the government must borrow funds from the private sector to finance its deficit, thereby increasing the interest rate. This increase in interest rate,
    Post a Comment
    Read more

    Econometrics: OLS estimates

      Let X and Y be column vectors and the sample has the size n: The vector beta contains both the coefficient of X as well as the coefficient for the intercept. This is equivalent to writing this equation: We will assume that the expected value of the error term is 0 (this can be done by construction), and that X is uncorrelated to epsilon. Assume the following is for population data. Let's prove that statement: Since we know that the covariance between X and epsilon is 0, it follows that the expected value of X times the error term must also be 0. Since we do not have access to the actual expected value of the distribution, let's use the sample data instead: The hat on the covariance signifies that this is a MM estimator. Let's use the fact that the sample mean of epsilon is also equal to 0, then:   Using the estimation for the covariance and that the expected value of the error term equals 0: Then we have: To get this result, you must use the properties of the summation op
    Post a Comment
    Read more