as revision.... Well, a couple of things I'm not sure about anyway 1.) Does anyone know why when Y (Nat inc) increases and MD(Y) (Money demand due to transaction/precautionary motives) increases, the resulting increase in interest rates doesn't spark a never ending spiral by increasing the MD(r) (Money demand due to asset motive) which continues to increase interest rates etc etc Also 2.) How does an increase in Money Demand translate to an increase in Prices (i.e. what are the intermediate steps in this process)? I'm not sure if either of these are covered in the core reading. But I'd be very impressed if anyone out there knows the answer Thanks Good luck with the revision, not long to go now!
Hi (1) Use the real money market model, with the supply of money fixed, ie independent of interest rates, and the demand for money downward sloping. The position of the demand for money curve depends on the demand for transactions and precautionary money (which depends on the level of real income) and the shape is determined by the demand for speculative money. As interest rates increase, the opportunity cost of holding savings in money (rather than bonds) increases, so people reduce their demand for speculative money (and save more in bonds). When national income increases, the demand for transactions and precautionary money increases. So the demand for money curve shifts to the right. If the supply of money is fixed, there is now excess demand for money. Interest rates rise to choke off this excess demand for money. Higher interest rates encourage people to hold their savings in bonds rather than money, so the demand for speculative money falls. Interest rates will rise until the demand for money equals the supply of money. (There is a movement along the demand for money curve.) Notice that the total demand for money hasn't changed, but people are now holding more transactions and precautionary money and less speculative money. (You seem to suggest that the higher interest rates will then cause the demand curve to shift to the right again(?) This won't happen, because a change interest rates causes a movement along the curve (this has already happened). The demand for money curve only shifts if there is a change in real income.) (2) I think you need to understand how a change in the money supply might cause prices to increase. An increase in the supply of money will cause interest rates to fall. This causes an increase in aggregate demand (increased consumption, investment and possibly net exports). If the economy is not at full capacity, this will cause an increase in real output/income. However, if real income is fixed (because the economy is at full capacity) then the pressure of increased demand will cause prices to rise. The quantity theory of money assumes velocity of circulation (V) and real output (Y) are fixed so there is a direct relationship between money supply (M) and prices (P).
