# 8 The Demand for Money and the Price Level

• Texbook: Chapter 10, Macroeconomics: A Modern Approach, Robert J. Barro, Cengage Learning, 2008.

• There is one video to watch: video 1

What is money?

## 8.2 Shoe-leather cost

Assume that a person receives $60,000 wage payment at the beginning of each month and make a consumption expenditure of$10,000 per month. The market he shops at has no ATM. Therefore, he needs to have cash in hand before he heads to the market. Calculate the average money holding for the following scenarios.

1. The consumption expenditure is broken into two transactions. Each costs $5,000. 2. The consumption expenditure is broken into four transactions. Each costs$2,500.

3. Given the total expenditure per month, what can make a consumer break his expenditure into more frequent transactions?

## 8.3 Wage payment frequency

Some households spend their monthly wage income totally every month. And they keep every income they receive in money. Assume that two of such household receive monthly wage income of \$60,000. One receives wage payment at the beginning of each month; the other receives two payments in a month (beginning of the month and the middle of the month). Which one would have a higher average money holding?

## 8.4 Existence of Money and Household Budget Constraints

When households increase their money withdrawal frequency, their money stays in the bank longer. It generates more interest income. However, income from this aspect of asset management is usually negligible compared to other income sources. Therefore, we leave it out of household’s income source.

1. Suppose in each period, money is fully used to facilitate all transactions in that period. Will the existence of money affect household’s budget constraint?

2. Suppose in each period, some money is kept unspent, not facilitating any transaction (maybe for emergency usage reason). In this case, will the existence of money affect household’s budget constraint?

## 8.5 Currency reform

Suppose that the government replaces the existing monetary unit with a new one so that one new dollar is equal to 10 old dollars. What happens to the price level and the interest rate?

## 8.6 Monetary policy

1. If the monetary policy is to target a fixed money stock, will the price level be pro-cyclical?

2. If the monetary policy is to target a fixed price level, will the money stock be pro-cyclical?

3. Central banks normally prefer price stability. However, money demand is usually strong during the holiday seasons. To stabilize the price, how would the central bank manage the money stock?

## 8.7 Money equilibrium

There is a common distinction between long run and short run in macroeconomics. For long run, we accept that price is flexible. For short run, price is sticky. Assume monetary policy is to target a fixed money stock.

1. For long run, money equilibrium determines the equilibrium price level of the economy. Holding others equal, there will be a relationship between money and price. Use a graph with x-axis being money stock and y-axis being price to draw the money demand. How does the increase of money supply affect prices?

2. For short run, since price level is fixed due to price stickiness. Holding others equal, there would be a relationship between money and the interest rate. Use a graph with x-axis being money stock and y-axis being the interest rate to draw the money demand. How does the increase of money supply affect the interest rate?

3. For short run, if monetary policy is targeting a fixed interest rate, what does the money supply curve look like?