Principles of Economics and Finance (7QQMO200)

MSc in Financial Policy & Regulation

King’s Business School
King’s College London

Lecture Notes: Lecture 3

Demand for Money; The quantity Theory; The IS–LM/AD–AS Model:

A General Framework for Macroeconomic Analysis

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I. The Demand for Money (Abel, Bernanke &Croushore, Sec. 7.3)
A. The demand for money is the quantity of monetary assets people want to hold in
their portfolios
Money demand depends on expected return, risk, and liquidity
Money is the most liquid asset
Money pays a low return
People’s money-holding decisions depend on how much they value liquidity against
the low return on money

B. Key macroeconomic variables that affect money demand

1. Price level
The higher the price level, the more money you need for transactions
Prices are 10 times as high today as 65 years ago, so it takes 10 times as much
money for equivalent transactions
Nominal money demand is thus proportional to the price level

2. Real income
The more transactions you conduct, the more money you need
Real income is a prime determinant of the number of transactions you conduct
So money demand rises as real income rises
But money demand is not proportional to real income, since higher-income
individuals use money more efficiently, and since a country’s financial

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 sophistication grows as its income rises (use of credit and more sophisticated
assets)
Result: Money demand rises less than 1-to-1 with a rise in real income

3. Interest rates
An increase in the interest rate or return on nonmonetary assets decreases the
demand for money
An increase in the interest rate on money increases money demand
This occurs as people trade off liquidity for return
Though there are many nonmonetary assets with many different interest rates,
because they often move together we assume that for nonmonetary assets
there’s just one nominal interest rate, i
The real interest rate, which affects saving and investment decisions, is r = i − e
The nominal interest paid on money is im

C. The money demand function

Md = P  L(Y, i) (7.1)

Md is nominal money demand (aggregate)

P is the price level
L is the money demand function
Y is real income or output
i is the nominal interest rate on nonmonetary assets
As discussed above, nominal money demand is proportional to the price level
A rise in Y increases money demand; a rise in i reduces money demand
We exclude im from Eq. (7.1) since it does not vary much
Alternative expression:

Md = P  L(Y, r + e) (7.2)

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 A rise in r or  e reduces money demand
Alternative expression:

Md/P = L(Y, r + e) (7.3)

The left side of Eq. (7.3) is the demand for real balances, or real money demand

D. Other factors affecting money demand

Wealth: A rise in wealth may increase money demand, but not by much
Risk
a. Increased riskiness in the economy may increase money demand
b. Times of erratic inflation bring increased risk to money, so money demand
declines
Liquidity of alternative assets: Deregulation, competition, and innovation have
given other assets more liquidity, reducing the demand for money
Payment technologies: Credit cards, ATMs, and other financial innovations reduce
money demand

E. Application: Bitcoin and cryptocurrencies

Cryptocurrencies, such as Bitcoin, do not exist in physical form but only as records
in a computer system
Bitcoin uses blockchain technology to record who owns how many bitcoins
Cryptocurrencies allow for anonymous transactions; so are sometimes used by tax
evaders and criminals
Blockchain works by using public records verified by others and replicated by many
computers throughout the system; the technology has many possible business
applications
Shortcomings of cryptocurrencies include high transactions costs and lack of stable
value, plus some questions about security
A new class of cryptocurrencies, called stablecoins, hopes to maintain a stable value
and could potentially be used as money

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F. Elasticities of money demand
How strong are the various effects on money demand?
Statistical studies on the money demand function show results in elasticities
Elasticity: The percent change in money demand caused by a one percent change in
some factor
Income elasticity of money demand
a. Positive: Higher income increases money demand
b. Less than one: Higher income increases money demand less than
proportionately
c. Goldfeld’s results: income elasticity = 2/3
Interest elasticity of money demand
Small and negative: Higher interest rate on nonmonetary assets reduces money
demand slightly
Price elasticity of money demand is unitary, so money demand is proportional to the
price level

G. Velocity and the quantity theory of money

Velocity (V) measures how much money “turns over” each period
V = nominal GDP/nominal money stock = PY/M (7.4)

Plots of velocity for M2 shows a downward trend over time

Plots of money growth shows that money growth has fluctuated considerably, rising
especially rapidly following the pandemic recession

Quantity theory of money: Real money demand is proportional to real income

If so,

Md/P = kY (7.5)

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 Assumes constant velocity, where velocity isn’t affected by income or interest
rates
But velocity of M1 is not constant; it rose steadily from 1960 to 1980 and has
been erratic since then
Part of the change in velocity is due to changes in interest rates in the
1980s
Financial innovations also played a role in velocity’s decline in the early
1980s
M2 velocity is closer to being a constant, but not over short periods

IV. Asset Market Equilibrium (Abel, Bernanke &Croushore, Sec. 7.4)

A. Asset market equilibrium—an aggregation assumption

Assume that all assets can be grouped into two categories, money and nonmonetary
assets
a. Money includes currency and checking accounts
(1) Pays interest rate im
(2) Supply is fixed at M
b. Nonmonetary assets include stocks, bonds, land, etc.
(1) Pays interest rate i = r +  e
(2) Supply is fixed at NM

Asset market equilibrium occurs when quantity of money supplied equals quantity
of money demanded
md + nmd = total nominal wealth of an individual
Md + NMd = aggregate nominal wealth (from adding up individual wealth) (7.6)
M + NM = aggregate nominal wealth (supply of assets) (7.7)
Subtracting (7.7) from (7.6) gives (Md − M) + (NMd − NM) = 0 (7.8)
So the excess demand for money (Md − M) plus the excess demand for
nonmonetary assets (NMd − NM) equals 0.

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 So if money supply equals money demand, nonmonetary asset supply must equal
nonmonetary asset demand; then the entire asset market is in equilibrium

B. The asset market equilibrium condition

1. M/P = L(Y, r +  e) . That is, real money supply = real money demand
M is determined by the central bank
 e is fixed (for now)
The labor market determines the level of employment; using employment in the
production function determines Y
Given Y, the goods market equilibrium condition determines r

With all the other variables in Eq. (7.9) determined, the asset market equilibrium
condition determines the price level
a. P = M/L(Y, r + e) (7.10)
b. The price level is the ratio of nominal money supply to real money demand
c. For example, doubling the money supply would double the price level

V. Money Growth and Inflation (Abel, Bernanke &Croushore, Sec. 7.5)

A. The inflation rate is closely related to the growth rate of the money supply
Rewrite Eq. (7.10) in growth-rate terms:

P/P = M/M − L(Y, r + e)/L(Y, r + e) (7.11)

If the asset market is in equilibrium, the inflation rate equals the growth rate of the
nominal money supply minus the growth rate of real money demand
To predict inflation we must forecast both money supply growth and real money
demand growth
In long-run equilibrium, we will have i constant, so we look just at growth in Y
Let Y be the elasticity of money demand with respect to income
Then from Eq. (7.11),

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  = M/M − Y Y/Y (7.12)

Example: If output grows 3% per year, the income elasticity of money demand is
2/3, and the money supply is growing at a 10% rate, then the inflation rate
will be 8%

B. Application: money growth and inflation in the European countries in transition

Though the countries of Eastern Europe are becoming more market-oriented, Russia
and some others have high inflation because of rapid money growth
Both the growth rates of money demand and money supply affect inflation, but (in
cases of high inflation) usually growth of nominal money supply is the most
important factor
For example, if the income elasticity of money demand were 2/3 and real output
grew 15%, real money demand would grow 10% (= 2/3  15%); or if income
fell 15%, real money demand would fall 10%
So money demand does not vary much, no matter how well or poorly an
economy is doing, but nominal money supply growth differs across countries
by hundreds of percentage points, so large inflation differences must be due to
money supply, not
money demand
In the Abel, Bernanke &Croushore Text Figure 7.4 shows the link between money
growth and inflation in these countries; inflation is clearly positively associated
with money growth
So why do countries allow money supplies to grow quickly, if they know it will
cause inflation?
a. They sometimes find that printing money is the only way to finance
government expenditures
b. This is especially true for very poor countries, or countries in political crisis

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 C. The inflation rate and the nominal interest rate
1. Expectations cannot be observed directly, except perhaps through surveys
2. If money growth is not expected to change much and if factors affecting money
demand are stable, inflation may not change much, so the expected inflation rate
would be approximately equal to the actual inflation rate
3. If the real interest rate is stable, then the nominal interest rate will move one for
one with inflation

Inflation and nominal interest rates have tended to move together

But the real interest rate is clearly not constant
The real interest rate was negative in the mid-1970s and then became much
higher and positive in the late-1970s to early-1980s; the real interest rate
turned negative again following the financial crisis of 2008

The inflation rate rose sharply in 2021, with nominal interest rates remaining
near zero

The IS–LM/AD–AS Model: A General Framework for Macroeconomic

Analysis (Chapter 9)

◼ Learning Objectives

A. Combine the labor market (Chapter 3), the goods market (Chapter 4), and the asset market
(Chapter 7) into a complete macroeconomic model (for a closed economy)
B. Although the IS–LM model was originally a Keynesian model because it assumes prices are
fixed, by allowing prices to adjust, it is possible to use the IS–LM framework to discuss the
classical approach
C. Using one model for both approaches (the classical model in Chapter 10 and the Keynesian
model in Chapter 11) avoids the need to learn two different models and helps show clearly
both the similarities and the differences of the two approaches

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◼

The FE Line: Equilibrium in the Labor Market

A. How equilibrium in the labor market leads to employment at its full-employment level N

and output at Y

B. If we plot output against the real interest rate, we get a vertical line at Y = Y , since labor
market equilibrium is unaffected by changes in the real interest rate

C. Factors that shift the FE line

1. Y is determined by the full-employment level of employment and the current levels of

capital and productivity; any change in these variables shifts the FE line
2. Factors that shift the full-employment line
a. The full-employment line shifts right because of
(1) a beneficial supply shock
(2) an increase in labor supply
(3) an increase in the capital stock
b. The full-employment line shifts left when the opposite happens to the three factors
above

The IS Curve: Equilibrium in the Goods Market (Sec. 9.2)

The goods market clears when desired investment equals desired national saving
Adjustments in the real interest rate bring about equilibrium
For any level of output Y, the IS curve shows the real interest rate r for which the goods
market is in equilibrium

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Derivation of the IS curve from the saving-investment diagram

Figure 9.3

Similarly, a change that increases desired national saving relative to desired investment
shifts the IS curve down and to the left

Summary of the factors that shift the IS curve

The IS curve shifts up and to the right because of
(1) an increase in expected future output
(2) an increase in wealth
(3) a temporary increase in government purchases
(4) a decline in taxes (if Ricardian equivalence doesn’t hold)
(5) an increase in expected future TFP
(6) a decrease in the effective tax rate on capital

The IS curve shifts down and to the left when the opposite happens to the six factors
above

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The LM Curve: Asset Market Equilibrium
The interest rate and the price of a nonmonetary asset
The price of a nonmonetary asset is inversely related to its interest rate or yield
a. Example: A bond pays $10,000 in one year; its current price is $9615, and its interest
rate is 4%, since ($10,000 − $9615)/$9615 = 0.04 = 4%
b. If the price of the bond in the market were to fall to $9524, its yield would rise to
5%, since ($10,000 − $9524)/$9524 = 0.05 = 5%
2. For a given level of expected inflation, the price of a nonmonetary asset is inversely
related to the real interest rate

The equality of money demanded and money supplied

Equilibrium in the asset market requires that the real money supply equal the real quantity
of money demanded
Real money supply is determined by the central bank and isn’t affect by the real interest
rate
Real money demand falls as the real interest rate rises
Real money demand rises as the level of output rises
The LM curve is derived by plotting real money demand for different levels of output and
looking at the resulting equilibrium

The LM curve shows the combinations of the real interest rate and output that clear the
asset market
Intuitively, for any given level of output, the LM curve shows the real interest rate
necessary to equate real money demand and supply. Thus the LM curve slopes
upward from left to right

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Factors that shift the LM curve
Any change that reduces real money supply relative to real money demand shifts the LM
curve up
For a given level of output, the reduction in real money supply relative to real money
demand causes the equilibrium real interest rate to rise
The rise in the real interest rate is shown as an upward shift of the LM curve
Similarly, a change that increases real money supply relative to real money demand shifts
the LM curve down and to the right
The factors that shift the LM curve
The LM curve shifts down and to the right because of
(1) an increase in the nominal money supply
(2) a decrease in the price level
(3) an increase in expected inflation
(4) a decrease in the nominal interest rate on money
(5) a decrease in wealth
(6) a decrease in the risk of alternative assets relative to the risk of holding money
(7) an increase in the liquidity of alternative assets
(8) an increase in the efficiency of payment technologies

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 b. The LM curve shifts up and to the left when the opposite happens to the eight factors
listed above

Changes in the real money supply

An increase in the real money supply shifts the LM curve down and to the right

Changes in real money demand

An increase in real money demand shifts the LM curve up and to the left

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