1° PART 2° PART 3° PART

(Macroeconomics) (Central Banking) (Optimum Currency Area)

14. Demand for Money: From Classical 02. Money Supply: Basic Concepts 10. History of Monetary Cooperation
Theory to Keynes (Mishkin Ch. 14) ()
(Mishkin Ch. 19)  Monetary aggregates
 Functions of money  Monetary base
 Quantity theory of money  Money multiplier
 Keynesian theory
 Friedman’s theory of demand
04. Monetary Policy Objectives and the 03. Monetary Policy Instruments 13. The fiscal and non-fiscal roots of
Phillips Curve (Mishkin Ch. 15) the crisis: theory and facts
()  Open market operations ()
 IS-LM model to AD  Standing facilities
 Phillip Curve and AS  Minimum reserve
 Adaptive expectations requirements
 Rational expectations
 AD-AS model
00. The AD-AS Model Main Elements 06. The Theory-Driven Institutional Set 11. European Monetary Unification
() Up of Central Banks ()
(Mishkin Ch. 16)
 Money targeting
 Inflation targeting
07. Why We care About Inflation 05. The Barro-Gordon Model 12. Optimal Currency Area Theory
() () ()
 Fisher Rule  AD-AS model  Costs
 Rational expectations  Benefits
 Barro-Gordon model  Costs vs. benefits
 Inflation bias (inf.targ. 2%)
08. Markets in Open Economies 15. Monetary Policy Transmissions
() (Mishkin Ch. 23)
LEGENDA
 PPP  Importante
09. Monetary Policy in Open Economies 16. Monetary Policy Transmission:  Secondario
() methods and evidence
()  Domanda attualità
 William
1. Come viene descritta la domanda di moneta dell’approccio di portafoglio? (Slide 6)
2. Il livello dei prezzi è 2, il reddito nominale ammonta a 100 euro, la domanda di moneta a 50 euro. Qual è il valore
della velocità di circolazione della moneta? Immaginando, come nei primi classici, una velocità di circolazione
costante, che cosa accade al livello dei prezzi se la domanda di moneta aumenta da 50 a 100 euro?
3. Che relazione esiste tra la curva di offerta aggregata e la curva di Phillips?
4. Usando il modello IS-LM si descriva l’impatto di un’espansione monetaria sul tasso di cambio (flessibile) e gli effetti
di brevissimo e quindi breve-medio termine sulla bilancia commerciale.
5. Il governo di un paese che è in regime di cambi fissi opera un’espansione fiscale. Si descrivano gli effetti sulle
principali variabili macroeconomiche, utilizzando il modello IS-LM. Come cambia la dinamica descritta se il paese
in questione è non in regime di cambi fissi ma membro dell’unione monetaria europea in cui le politiche fiscali
sono rimaste nazionali ma la politica monetaria è unica
6. The Argentina’s current (2018) economic crisis
 QUESTIONS & ANSWERS OF MONETARY POLICY
(questions in bold are examples of the third question)

1. Come viene descritta la domanda di moneta dell’approccio di portafoglio? (Slide 6)

1. The first to introduce a classification on money according to its functions: a unit of account, a store of value, a
medium of exchange, with Keynes three motives for holding money: the transactions, the precautionary, and the
speculative motives was J. Hicks in his seminal work “The two triads. Lecture 1”.
The transaction motive, for Keynes but also in the classical approach, individuals are assumed to hold money
because it is a medium of exchange that ca be used to carry out everyday transactions, like the classical
economists, Keynes considered the transactions component of the demand form money to be proportional to
income.
The precautionary motive, introduced newly by Keynes, recognize that people hold money as a cushion against an
unexpected need. For Keynes, these balances are determined primarily by the level of transactions that they
expect to make in the future and that these transactions are proportional to income.
Money demand with a transaction and precautionary motive is MD=f(Y).
The precautionary demand for money is negatively related to interest rates.
The speculative motive, another reason for which people hold money is as a store of wealth, as a form of financial
investment alternative to assets (speculation based on difference between current and future return on assets).
Money demand with a speculative motive is MD=f(i), the speculation revolves around the difference between the
current and the expected interest rate.
The different motives received differentiated attention across schools of economic thought.
Quantity theory of money (classical theory)
In the classical theory (Fisher 1911) the money demand is caused only for transaction purposes, and in the
Equation of Exchange (identity): M*V = P*Y(or T)
according to Fisher V, the velocity of money, is constant in the medium-term and a function of institutional factors
and therefore constant in the short-run, as such the quantity of money supplied affects directly the price level: M
= P.
In the Neoclassical theory of demand for money, put forward by Marshall and Pigou from the Cambridge School,
the money if used for transaction and for precautionary motive (both proportional to income), as such the public
wants to hold a certain constant proportion of their income as money:
Cambridge equation: MD= k*P*YN
in which the velocity of money is a function of institutional factors and therefore constant in the short-run, and in
which income is determined by real factors (Y = YN). K is called the Cambridge k, and it shows what proportion of
money income the public likes to hold in the form of money. The quantity theory implies direct correlation
between a rise in money supply and a rise in price level, the real quantity of money (M/P) is constant, and more
importantly the assumption of Money neutrality (variations of M do not affect Y).
Summary:
Classical theory (Fisher) Cambridge theory
 Money is used for transaction (current  Money is used for transaction (current
consumption) consumption) and for precautionary motive
 The velocity of money is a function of (future consumption of a certain type)
institutional factors and therefore constant  The velocity of money is a function of
in the short-run institutional factors and therefore constant
 The quantity of money supplied affects in the short-run
directly the price level: M = P  The quantity of money demanded: MD = kPY

Keynesian theory
According to Keynes’s theory of the demand of money, which he called the liquidity preference theory, he
postulated that there are three motives behind the demand for money: the transactions motive [current
consumption], the precautionary motive [future consumption] and the speculative motive [store of value].
Money demand with a transaction and precautionary motive is MD = f(Y). Money demand with a speculative
motive is MD = f(i), the speculation revolves around the difference between the current and the expected interest
rate. Notation:
MD = Demand for money (nominal), MS = Money supply (nominal), P = price level, Y = real output (while Yn =
nominal output), i = nominal interest rate, r = real interest rate, Pe = expected inflation.
Features of MD with a speculative
motive:
 Money has maximum liquidity
 Bonds is the only alternative
 Bonds have inverse relation
between interest rate (i) and price
(PT)
 Current interest rate (i)
matters not the
e
expected rate (i )
 In the Keynes’ analysis an
individual holds his wealth
in either all money or all
bonds depending upon his
estimate of the future rate of interest.

The portfolio approach to demand of money put forward by Tobin, Baumol and Friedman is a response to the
limits to Keynes’ theory:
 The gap between current level of the interest rate and expected rate (normal level) tends to disappear in
the long-run
 Speculative motive is secondary to the transaction motive, implying low interest rate elasticity of money
demand, while the modern theories of money demand show that money held for transaction purposes is
interest elastic
 The public, unrealistically holds either money or bonds, for Keynes, while it is possible a combination of
both

James Tobin explained, in his Portfolio Approach to demand for money, that rational behavior on the part of the
individuals is that they should keep a portfolio of assets which consists of both bonds and money, so the problem
is what proportion of portfolio to keep in the form of money and what in interest-bearing bonds. According to
Tobin, individual’s behavior shows risk aversion, they prefer less risk to more risk at a given rate of return and are
uncertain about future rate of interest.

Baumol’s Investory Approach to Transactions Demand for Money

Baumol concentrated on transactions demand for money from the viewpoint of the inventory control or inventory
management similar to the inventory management of goods, asserting that individuals hold inventory of money
because this facilitate transactions (i.e. purchases) of goods and services.
For both Tobin and Baumol the transaction demand for money depends is sensitive to rate of interest; interest
represents the opportunity cost of holding money instead of bonds, saving and fixed deposits. The higher the rate
of interest, the greater the opportunity cost of holding money. There is also a benefit to holding money, the
avoidance of transaction costs.

Friedman’s Theory of Demand of Money

In 1956, Milton Friedman developed a theory of the demand for money in the article “The quantity theory of
money: a restatement”, in which he expressed his formulation of the demand for money:
 According to Friedman, individuals
hold money for the services it provides
to them. His approach to demand for
money, unlike Keynes’, does not
consider any motives for holding
money, nor does it distinguishes
between speculative and transactions
demand for money. The demand for
money is considered merely as an
application of a general theory of
demand for capital assets.

Friedman, unlike Keynes, including many assets as alternatives to money, recognized that more than one interest
rate is important to the operation of the aggregate economy. Also, he viewed money and goods as substitutes,
the public chooses between them when deciding how much money to hold.
Unlike Keynes’s theory, which indicates that interest rates are an important determinant of the demand for
money, Friedman’s theory suggests that changes in interest rates should have little effect on the demand for
money; because changes in interest rates should have little effect on incentives for holding other assets relative
to money, these incentive terms remain relatively constant, because any rise in the expected returns on other
assets as a result of the rise in interest rates would be matched by a rise in the expected return on money. So
Friedman’s money demand function, in which permanent income is the primary determinant of money demand
can be approximated by:

Another issue stressed by Friedman was the stability of the demand for money function. Demand
for money can be predicted accurately by the money demand function, combined with his view
that the demand for money is insensitive to changes in interest rate, this means that velocity is
highly predictable, yielding a quantity theory conclusion that money is the primary determinant of aggregate
spending. The conclusion that money is the primary determinant of aggregate spending was the basis of
monetarism, the view that the money supply is the primary source of movements in the price level and aggregate
output.
1. Chiarire il concetto di “trappola della liquidità”
1. An extreme case of ultra-sensitivity of the demand for money to interest rates in which monetary policy has no
direct effect on aggregate spending, because a change in the money supply has no effect on interest rates. An
increase in money supply fails to generate a fall in the interest rate because there’s an inferior limit to it; when
nobody is willing to hold bonds and all the public want just money.
At negative nominal interest rates, people would find money strictly preferable to bonds, and bonds therefore
would be in excess supply. In this situation macroeconomic policy makers are trapped in a situation where they
may no longer be able to steer the economy through conventional monetary expansion. Economists therefore
recommend that if possible, central banks avoid the zero lower bound (ZLB) on the nominal interest rate.

If the demand for money is ultrasensitive to interest rate, a tiny

change in interest rates produces a very large change in the
quantity of money demanded. Hence the demand for money is
flat.

(trappola della liquidità: c’è un limite inferiore ai livelli

ammissibili del tasso di interesse. Quando nessuno è disposto
a tenere titoli e tutti tengono in portafoglio qualsiasi quantità
di moneta

Starting in 2014, several major central banks, most prominently the ECB, started to push nominal interest rates
into negative teerritory, effectively by charging commercial banks on the cash they hold at the central bank.
The dilemma a central bank faces when the economy is in a liquidity trap slowdown can be seen by considering
the interest parity condition (Equilibrium in the foreign exchange market, i.e. deposits of all currencies must offer
the same expected rate of return when returns are measured in comparable terms) when the domestic interest
rate R = 0,

Assuming for the moment that the expected future exchange rate Ee, is fixed. Supposing the central bank raises
the domestic money supply so as to deprecite the currency temporarily (that is, to raise E today but return the
exchange rate to the level Ee later).
Thhe interest parity condition shows that E cannot rise once R = 0 because the interest rate would have to become
negative, Instead, despite the increase in the mmoney supply, the exchange rate remains steady at the level

The currency cannoo deprecite further.

The usual argument that a temporary increase in the money supply reduces the interest rate (and derpecites the
currency) rests on the assumption that people will add money to their portfolios only if bonds become less
attractive to hold. At an interest rate of R = 0, however, people are indifferent about trades between bonds nad
money, both yield a nominal rate of return rate equalt to zero. An open-market purchase of bonds for money will
not disturb the markets. A central bank that progressively reduces the money supply by selling bonds will
eventually succedd in pushing the interest rate up ,the economy cannot function without some money, but that
possibility is not helpful when the economy is ina slump and a fall in interest rates is the medicine that it needs.
2. Usando il modello IS-LM si descriva l’impatto di un’espansione monetaria sul tasso di cambio (flessibile) e gli effetti
di brevissimo e quindi breve-medio termine sulla bilancia commerciale.
2. Brevissimo termine: An example of the J-curve effect is seen in economics when a country’s trade balance initially
worsens following a devaluation or depreciation of its currency. The higher exchange rate first corresponds to
more costly imports and less valuable exports, leading to a bigger initial deficit or a smaller surplus. Due to the
competitive, relatively low-priced exports, the affected country’s exports of the goods in question start to increase
as outside demand for the lower-priced option increases. Local consumers also purchase less of the more
expensive imports and focus on local goods as the exchange rate makes certain locally produced items more
affordable that the imported counterpart. The trade balance eventually improves to better levels compared to
before devaluation. In cases where a country’s currency appreciates, a reverse J-curve may occur. This is based
on the country’s associated experts becoming more expensive for importing countries than experienced
previously. If other countries are able to offer the good at a more affordable rate, the country with a higher
currency value may see demand drop in the export arena. Additionally, local consumers may favor imported
versions of goods if they are available at a lower cost.
Medio termine:
3. Il livello dei prezzi è 2, il reddito nominale ammonta a 100 euro, la domanda di moneta a 50 euro. Qual è il valore
della velocità di circolazione della moneta? Immaginando, come nei primi classici, una velocità di circolazione
costante, che cosa accade al livello dei prezzi se la domanda di moneta aumenta da 50 a 100 euro?
(Chapter 19)
3. P = 2; Y = 100; MD =50; V = ?  V = (P*Y)/MD = 4
P = ?; Y = 100; MD = 100; V = 4  P = (V*MD)/Y = 4
4. Che relazione esiste tra la curva di offerta aggregata e la curva di Phillips? (Slide 4)
(Che relazione esiste tra gli obiettivi di politica monetaria (Ut ~ U* e πt < 2%) e la curva di Phillips)
5. The output gap is an indicator of future inflation as stipulated in Phillips curve theory. It indicates that changes in
inflation are influenced by the state of the economy relative to its productive capacity, as well as by other factors.
The Phillips curve describes the relationship between inflation and unemployment. The expectation-adjusted
PC specifies that inflation depends on: expected inflation, cyclical unemployment, namely the deviation of
actual unemployment from the natural unemployment rate (U – Un
The Phillips curve equation and the short-run aggregate supply equation represent essentially the same
macroeconomic ideas. In particular, both equations show a link between real and nominal variable that causes
the classical dichotomy (the theoretical separation of real and nominal variables) to break down in the short
run. According to the short-run aggregate supply equation, output is related to unexpected movements in the
price level. According to the Phillips curve equation, unemployment is related to unexpected movements in
the inflation rate. The aggregate supply curve is more convenient when we are studying output and the price
level, whereas the Phillips curve is more convenient when we are studying unemployment and inflation. But
we should not lose sight of the fact that the Philips curve and the aggregate supply curve are two sides of the
same coin.
The Phillips curve in its modern form states that the inflation rate depends on three forces:
1. Expected inflation
2. The deviation of unemployment from the natural rate (unemployment gap), called cyclical
unemployment
3. Supply/price shocks
To make the Phillips curve useful for analyzing the choices facing policymakers, we need to specify what
determines expected inflation. Two ways:
 Adaptive expectations: it assumes that form their expectations of inflation based on recently
observed inflation, this implies that inflation has inertia. That is, like an object moving through space,
inflation keeps going unless somehtins acts to stop it.
 Rational expectations: it assumes that people optimally use all the available information, including
information about current government policies, to forecast the future. According to the theory of
rational expectations, a change in monetary or fiscal policy will change expectations, and an evaluation
of any policy change must incorporate this effect on expectations. If people do form their expectations
rationally, then inflation may have less inertia that first appears.

The second term in the Phillips curve equation shows that cyclical unemployment, the deviation of
unemployment from its natural rate, exerts upward or downward pressure on inflation. Low unemployment
pulls the inflation rate up. This is called demand-pull inflation because high aggregate demand is responsible
for this type of inflation. High unemployment pulls the inflation rate down.

The third term shows that inflatjion also rises and falls because of supply shocks. An adverse supply shock
implies a positive value and causes inflation to rise. This is called cost-push inflation.

Considering the options the PC curve gives to a plicymaker who can influence aggregate demand with
monetary or fiscal policy. At any moment, expected inflation and supply shocks are beyond the policymaker’s
immediate control. Yet, by chanign aggregate demand, the policymaker can alter output, unemployment, and
inflation. The policymaker can expand aggregate demand to lower unemployment and raise inflation, or
depress aggregate demand to raise unemployment and lower inflation.
6. Il governo di un paese che è in regime di cambi fissi opera un’espansione fiscale. Si descrivano gli effetti sulle
principali variabili macroeconomiche, utilizzando il modello IS-LM. Come cambia la dinamica descritta se il paese
in questione è non in regime di cambi fissi ma membro dell’unione monetaria europea in cui le politiche fiscali
sono rimaste nazionali ma la politica monetaria è unica. (de Grauwe)
6. Answer: