factors affect the Aggregate Demand for Money [Md] from textbook assuming fixed money supply.
intrest rate: r UP >>> Md DOWN
price level: P UP >>> Md UP
Y (real gdp): Y UP >>> Md UP
also. liquidity, XR, and risk influence Md
So here is my question :
assuming money supply is constant and output (Y) increases 100%… 1 → 2
if we had one good in our economy, like a $1 dollar coffee in year one and in year two output increases to 2 coffees… doesnt the price go from $1 per coffee to .50c per coffee.. effectively keeping Money Demand constant?
i think the problem im having is the idea of economic growth and inflation… assuming we have a fixed money supply of $1 and infinite growth… why cant the value of $1 stay the same but the price level go down to accomodate more goods…
please let any actual economists answer this for certain, but the way it’s hitting me is a mixing of relative values between the years in this scenario … that, in assuming an unchanged supply of money as both an adequate store of value and medium of exchange, the doubling of output has doubled the purchasing power of that constant money supply - which therefore forces the nominal price of $1 coffee in Y1 to $0.50 in Y2 (since $1 supply is deemed adequate to fulfill the complete transaction of 2 coffees now). Otherwise, if you wish to keep the nominal price in Y2 at $1 coffee, then you’d be forced to double the supply of money to $2 - which would be required to fulfill the complete transaction of 2 coffees (that inflation’s reaction).
Heres the textbook explation of this problem… but im still confused as to why inflation is necessary… is this a case of keynesian assumption of growth requiring inflation? when i brought this up in class my professor made me look like an idiot when he explained that in year 2 the price goes to $2, year 3 $3… so more money is demanded… [:-*]
Aggreate Money Demand
Our discussion of how individual households and firms determine their demands for money can now be applied to derive the determinants of aggregate money demand, the total deman for money by all households and firms in the economy.’
the interest rate. A rise in the interest rate causes each individual in the economy to reduce her demand for money. All else equal, aggregate money demand falls when interest rate rises.
the price level. If the price level rises, individuals must spend more money than before to purchase their ususal weekly baskets of goods and services. To maintain the same level of liquidity as before the price level increase, they will have to hold more money.
>>Real National Income. When income/output rises. more goods and services are being sold in the economy. This increase in the real value of transactions raises demand for money, given the price level.
My point is that the REAL VALUE of transactions can INCREASE with a FIXED money supply by decreasing the price level [$1.00 → $0.50] and increasing output.. [1-> 2]
Quatity year 2 * Price year 1 equals REAL VALUE increase in year 2 with a lower price level, no change in money demand… all else equal!
AM I CRAZY or is this model too simplified or is the book making a flawed assumption???
A similar question arose in my macroeconomics class - the professor was hard-pressed to give a reasonable answer. I just took it for granted that this was a feature of the model we were studying, but it’s never made much sense to me (why would money demand increase if purchasing power remaind constant?) Perhaps someone with more knowledge could explain it?
The Anatomy of Growth, by Sean Corrigan in this site, posted 4-15-04 (short-cut below):“Inflation is not synonymous with rising prices, of course, but rather is the prime causative factor. Inflation is a situation where more money exists—however “money is” defined—than is subjectively required by individuals.”
gotta keep this on the board now … cuz I don’t want mine to be the last word on this most interesting question, that I want to know the correct answer to as much as the originator. Thanks!
Your prof is wrong. Why would the price level rise in Y2 and Y3? Price is a funciton of demand and would not rise unless there was more money in the system or an increase in demand from any of a number of other reasons (such as a decline in demand or price for other products). Even GDP is a function of the money supply and velocity. Since V does not change much, and if the money supply remains constant, GDP would also remain constant and the demand for money would remain about the same, depending on expectations of future needs. If expectations were that political and economic situations were to remain stable, then the demand for cash balances should remain constant. Increased output would only have the effect of lowering the price level. This is what the Keynesians (and the government) are afraid of. To Keynesians the balance sheet must increase to be thought of as profitable (even though more product would be sold), and to the government tax revenue would remain constant instead of increasing. During price inflation tax revenues increase even though this represents dipping into capital rather than profits.
Initially I would suggest sticky prices that cannot yet be adjusted for - this would suggest that the fluctuation in mD isn’t large and expectations are that prices will settle back to their previous state - but I could also see an offsetting fluctuation in mS compensating. Though I didn’t really read the original post in depth and I’m only going off of about an hour or so of sleep here. [|-)]