week 5

• the liquidity preference theory is the second and more relevant theory on why inflation occurs
• Liquidity preference theory states there are 3 motives for holding money; Transactions, Precautionary and Speculation
• Transactions involves using money as payment, and demand for money for this may be affected by new methods for payment (payment technology)
• Precautionary demand for money involves people holding money for unexpected needs. this has reduced over time, but does involve people holding money in the bank when it is very liquid and accessible
• Speculative demand for money involves people holding money as a store of wealth
• by combining the three demands for money, Liquidity preference theory states that the demand for real money balances is a function of interest rate (negative) and real income (positive)
• the equation for Liquidity Preference Theory is PY/Md = Y/L(i,Y) = V
• in Liquidity preference theory, velocity is not constant, and movements in interest rate will induce procyclical movements in velocity
• in liquidity preference theory, velocity will change as expectations about future normal levels of interest rates change
• he more sensitive demand for money is to interest rates, the more unpredictable money velocity will be, and the less clear the link between money supply and spending will be
• the portfolio theory states that money demand is also affected by wealth, risk, and liquidity of other assets, alongside the liquidity preference factors
• according to the portfolio theory of money demand, more liquid other assets reduced demand for money, as it is more easily substituted
• according to the Quantity Theory of Money, money supply has a causal, proportional relationship with price level
• the Quantity theory of Money uses the equation M V = P Y
• according to the quantity theory of money, if the central bank increases money supply (M), P or Y has to increase
• according to the quantity theory of money, in the long run Y is not determined by M, so an increase in M will only increase P (inflation)
• in the short run, a change in M will cause a change in P or Y
• the quantity theory of money implies that movements in the price level come only from changes in the quantity of money
• the quantity theory of money implies interest rates have no effect on the demand for money, as demand for money is only a function on income
• In the quantity theory of money, the velocity of money (V) is fixed
• if money demand is unstable, Quantity Theory may be breached, due to money velocity not being stable, and the quantity of money (M) being less linked to spending (Y)
• the consumption function can be modelled as C = Cbar + mpc (Y-T) where Cbar is autonomous spending, and mpc(Y-T) is consumption that depends on disposible income
• Fixed investment is always planned
• inventory investment can be unplanned
• The investment Function is I = I bar - (d * ri) where I bar is autonomous investment, and (d * ri) is the investment that depends on interest rates
• Net Exports are calculated using the equation NX= NX bar - (x * exchange rate) where NX bar is autonomous net exports, and (x * exchange rate) are the net exports due to exchange rate
• the economy reaches equilibrium because of the negative relationship between investment and interest rates
• the economy reaches equilibrium because of the negative relationship between real exchange rates and net exports
• the Central bank sets a monetary policy rate, which is a proxy for the real interest rate
• the MP curve shows the relationship between the output and interest rate at a given time, but changes in inflation cause shifts in the MP curve over time
• the MP curve is the output of the Taylor Rule