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Chapter 7

ECN 301 Chapter Notes - Chapter 7: Nominal Interest Rate, Money Supply, Monetary Base

Course Code
ECN 301
David Lee

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Intermediate Macroeconomics 1: Theory
Week 5
Chapter 7
• In the 1970s, Canada experienced episodes of relatively mild (1 to 3%), creeping (4 to 7%) and
galloping (7 to 15%) inflation
• Inflation was at times large enough to cause significant economic and political trauma
– avoiding a repeat of the inflation of the 1970s remains a major goal of economic policy
The Flexible-Price Model
• The Classical dichotomy implies that real variables (real GDP, real investment spending, or the real
exchange rate) can be analyzed and calculated without considering nominal variables (price level)
– money is “neutral
• This is a special feature of the full-employment flexible-price model
• is wealth that is held in a readily-spendable form
• is made up of
– coin and currency
– chequing account balances
– other assets that can be turned into cash or demand deposits nearly instantaneously, without risk or cost
The Usefulness of Money
• Without money, market transactions would have to be performed through barter
• In a barter economy, market exchange would require the coincidence of wants
– you would have to have some good or service that someone wants and he or she would have to have
some good or service that you want
• Money also serves as a unit of account
– money is used as a yardstick to measure value or quote prices
• Anything that alters the real value of money in terms of its purchasing power will also alter the real
terms of existing contracts that use the money as a unit of account
The Demand for Money
• Businesses and households have a demand for money

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– they want to hold a certain amount of wealth in the form of readily-spendable purchasing power to
carry out transactions
• a higher level of spending means a larger money demand
• There is a cost of holding money
– cash and chequing deposits earn little or no interest
• Opportunity Cost of Holding Money: the lost interest and profits, etc.
The Quantity Theory of Money
• assumes that the only important determinant of the demand for money is the flow of spending
• can be summarized using
– the Cambridge (England) money-demand function
M=1/V *(P*Y)
– the quantity equation
M*V= P*Y
(P * Y) represents the total nominal flow of spending
• M is the quantity of money
• V is a measure of how fast money moves through the economy
– how many times the average unit of money is used to buy a final good or service
Determining the Price Level
• In the flexible-price model of the macroeconomy
– real GDP (Y) is equal to potential GDP (Y*)
– the velocity of money is determined by the sophistication of the banking system
– the money supply is determined by the central bank
P= V/Y *M
• If the price level is lower than the quantity equation predicts
– households and businesses will have more wealth in the form of money than they wish
• they will increase purchases
– sellers will note demand is strong and raise prices
The Money Stock
• The Bank of Canada determines the money stock in Canada
– the determination of the money stock is the basic task of monetary policy
• The Bank of Canada can directly impact the monetary base
• To reduce the monetary base, the Bank of Canada sells short-term government securities
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