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Money Market analysis (In long run (change price level) (The equation of…
Money Market analysis
The demand of money
The relationship between the interest rate and quantity of money (
negative
)
Higher
price level,
higher
demand of money
The
supply
of money is
independent
for the interest rate
Increase MS could decrease the interest rate
decrease MS could increase the interest rate
In the
short run
Money affect the economy by changing the
interest rate
MS ↑
Interest rate ↓
Investment ↑
AD ↑
Y (GDP) ↑
In
long run
(change
price level
)
The equation of
exchange
M x V=P x Y
V
velocity of money
P
Average price level
M
Quality of money
Y
Real GDP
P x V is the
nominal GDP
The quantity theory of money
If the velocity of money is stable, the equation of exchange could be used to predict the effects of changes in the money supply
In the long run,
increasing
the money supply
only increase
the price level
Rate of growth
of the money supply determines the
inflation rate
in the economy
Quantity equation--> growth rate
The
sum
if the growth rate of the individual variables
M/M x V/V = P/P x Y/Y
Active & Passive policy
Recessionary gap
1) Do nothing
(higher unemployment )
Cost of resource is lower, so the firms are willing to hire more workers to increase productions
SRAS shift right
to potential output (lower Price level)
Active policy
(expansionary policy)--> Higher inflation
Right shift the AD curve
Increase government spending
Expansionary gap
1) Do nothing
(Higher inflation)
SRAS shift left
2) Active policy
contractionary gap -->Higher unemployment
Problems with Active policy
Inaccuracy
of natural rate unemployment rate
Must work in
coordination
with each other
Must be willing to make
unpopular choice
Deal with
different lags
Recognition lag--> recession
The time to
recognize and identify
macroeconomic problems
Decision-making lag
To find
what to do
--> fiscal is longer
Implementation lag
Need to
introduce the change
in monetary or fiscal policy--> fiscal is longer
Effectiveness lag
Need
time for change
to effect the economy
Monetary
is in short run
Fiscal
is 3-6 months to take effect, 9-18 months before full impact on AD
Expectations and policy rules
Rational expectations
People base on all
available information
Adaptive expectation
They base on
their own expectation