Monetary Policy
The Role of Money and interest rates
QE
• Hopefully a better explanation
The transmission mechanism
One side
RISES
Other side
FALLS
Transmission Mechanism…. What would happen if IR’s
rise?
Transmission Mechanism if IR’s rise
Functions of Money
•
•
•
•
A medium of exchange
A store of value or wealth
A unit of account
A standard of deferred payment
Defining money
• Liquidity
– The degree to which financial assets can be
easily converted into money
Cash
Current
account
Narrow money M0
Deposit
account
Treasury
bills
Broad money M4
Property
Demand for Money
• Income
– The higher the income the greater demand
for money for spending
• Rate of interest
– The higher the rate the greater ‘yield’
– Nominal interest rates
– Real interest rates
KEYNESIAN DEMAND FOR MONEY LIQUIDITY PREFERENCE
• TRANSACTIONS DEMAND - this is money used for
the purchase of goods and services. The transactions
demand for money is positively related to real
incomes and inflation.
• PRECAUTIONARY BALANCES - this is money held
to cover unexpected items of expenditure. As with
the transactions demand for money, it is positively
correlated with real incomes and inflation.
• SPECULATIVE BALANCES - this is money not held
for transaction purposes but in place of other
financial assets, usually because they are expected to
fall in price.
Demand for money or the liquidity
preference curve
Financial innovation
Equilibrium rate of interest
• This assumes a
fixed money
supply
•
Using a liquidity preference diagram,
what would be the effect of the
following on the rate of interest
1.
2.
3.
4.
5.
A fall in the money supply
A rise in inflation
Increase in money substitutes
A fall in real national income
An increase in quantitative easing
Loanable funds theory
• Demand for funds comes from firms and
governments wanting to invest.
Example question
‘It is better to do everything you can to
prevent deflation before it begins, even
if there is only a small chance of it
occurring.’
0 7 Explain how monetary policy might be
used to prevent a period of deflation.
(15 marks)