IV.

Money market
1. Money Demand: the demand for
money refers to the desire to hold
money: to keep your wealth in the
form
of
money,
rather
than
spending it on goods and services
or using it to purchase financial
assets
suchfor
asHolding
bond orMoney
shares
2.Reasons
The Transactions Motive: since
money is a medium of exchange
it is required for conducting
transactions.

The
Precautionary
Motive:
unforeseen circumstances can
arise, such as a car breakdown.
Thus individuals often hold some
additional
money
as
a
precaution
The Speculative Motive: certain
firms and individuals who wish
to purchase financial assets
such as bonds or shares may
prefer to wait if they feel that
their price is likely to fall. In the
meantime they will hold idle
money balances instead

3.The Demand for Money Function:

the
relationship
between
the
demand for money and the interest
rate is described by the demand for

d
money function
M
f (Y , i )
This expression simply states that
the demand for money is a function
d
(f)
M of income Y and the interest rate
I
= denotes the nominal money
demand
Y = denotes nominal income (GDP)
and it captures the overall level of
transactions in the economy.

In fact, it is reasonable to assume

that
the
overall
level
of
transactions
is
roughly
proportional to nominal income.
The positive sign above Y denotes
that
there
is
a
positive
relationship between income and
demand for money: the higher the
level of income (transactions) the
higher the demand for money
i = is the interest rate and the
negative sign above it denotes the
negative relationship between the
interest rate and the demand for
money. The higher the interest

d. Determinant of money
demand
*Level of price:
MDn (nominal Money Demand
computing based on researched
price (usually higher than based
price)
MDr
(real
Money
Demand,
MD
n on based price
computing
depend
P
MDr MD const
(constant price).
MDn
P
MDr MD const

*Interest rate (i)

i increases (decreases) => MD
decreases (increases)
*Income (Y)
Y increases (decreases) => MD
increases (decreases)

MD
0

MD
1
M

io

MS
o

Eo
MDo

3. Equilibrium in the Money

Market: the equilibrium in the
money market requires that
money supply be equal to
money demand, that Ms=Md
This equilibrium condition tells
us that the interest rate must
be such that people are willing
to hold and amount of money
equal to the existing supply.
This equilibrium relation is also
called LM

*Note:
+ If I # i0 =>imbalance between
supply and demand which puts
pressure to push I up or down to
equilibrium point i0. When MS,
MD changes =>quilibrium point
(E) changes which leads to
changes of i0.

V. Monetary policy:
1. Expansionary monetary policy

2.Contractionary monetary policy

CHAPTER VI
Inflation and unemployment

I.unemployment:
Unemployment is the number
of people of working age who
are without work, but who are
available for work at current
wage rates. If the figure is to
be expressed as a percentage,
then it is a percentage of the
total labour force.

-The labour force is defined as:

those in employment (including
the self-employed, those in the
armed forces and those on
government training schemes)
plus those unemployed.
-The labour force doesnt include
people who are out of working
age, students, pupils, invalids.
People who are at working age
but unwilling to work doent
belong to labour force

Labour force

In
Workin
Popul g age
ation

Out

Labou
r force

Out of
labour
force

employmen
t
unemploym
ent

2. Computing
unemployment rate
u - Unemployment Rate): to be
expressed
by
fraction
of
unemployment with the total
labour force. It can be expressed
by percentage as the formula
below:
U (Unemployed): L (Labour Force):

U
u
100%
L

Unemployment is a problem
for the economy because:
Output and incomes are lost.
Human capital depreciates.
Crime may increase.
Human dignity suffers.

3. Types and causes of

unemployment:
Frictional unemployment occurs
when people leave their jobs,
either voluntarily or because
they are sacked or made
redundant,
and
are
then
unemployed for a period of time
while they are looking for a new
job. They may not get the first
job they apply for, despite a
vacancy existing. The employer
may continue searching, hoping
to
find
a
better-qualified
person.

Likewise,
unemployed
people
may choose not to take the first
job they are offered. Instead,
they may continue searching,
hoping that a better job will turn
up.
The
problem
is
that
information
is
imperfect.
Employers are not fully informed
about what labour is available;
workers are not fully informed
about what jobs are available
and what they entail. Both
employers
and
workers,
therefore,
have
to
search:
employers searching for the

Structural Unemployment refers

to unemployment arising because
there is a mismatch of skills and
job
opportunities
when
the
pattern of demand and production
changes. Examples in the UK
include unemployment resulting
from a decline in the production of
textiles, shipbuilding, cars, coal
and steel. Those workers who
become structurally unemployed
are available for work but they
have either the wrong skills for

Demand-deficient Unemployment
is also referred to Keynesian
unemployment. Demand-deficient
unemployment
occurs
when
aggregate
demand
falls
and
wages and prices have not yet
adjusted
to
restore
full
employment. Aggregate demand
is deficient because it is lower
than full-employment aggregate
demand which implies that output
is less than full employment
output.

Classical
Unemployment
describes the unemployment
created when the wage is
deliberately maintained above
the level at which the labour
market clears. It can be caused
either by the exercise of trade
union power or by minimum
wage legislation which enforces
a wage in excess of the
equilibrium wage rate.

II.Inflation
1. Definition
Inflation is a rise in the average
price of goods over time.
The term deflation is used to
describe a fall in the average price of
goods over time.
Deflation is very rare, but when it
occurs it can cause serious problems
in the economy. The inflation rate
is the percentage change in the price
level. The formula for the annual

2. Computing inflation
Gp:price growth
rate

Pt Pt 1
gp
100%
Pt 1

t-time
Pt-1: at previous time
Pt: : at current time (research
time)
P is to be expressed as follows:

P1Q1 P2Q2 ... Pn Qn

P
Q1 Q2 ... Qn

Why is inflation a problem?:

When inflation is present in the
economy, money is losing its
value. The higher the inflation
rate, the higher is the rate at
which money is losing value and
this fact is the source of the
inflation problem. Inflation is
said to be good for borrowers
and bad for lenders, and so
inflation can cause inequalities
in the economy. People on fixed
incomes (e.g. pensioners and
students) tend to suffer most
from inflation.

2. Types of inflation
*Moderate Inflation: inflation rate <
10%/nm, prices increases slowly..
Moderate
inflation
can
spur
production
because
price
increases leading to highet profit
for enterprises,therefore, firms
will increases quantity.
*Galloping Inflation: inflation rate
is from 10% to 99% per year. This
type will destroy economy and curb
engines of economy.

*Hyper Inflation: is defined as

inflation that exceeds 100%
percent per year.
Costs such as shoe-leather and
menu costs are much worse with
hyperinflation and tax systems
are grossly distorted. Eventually,
when costs become too great
with hyperinflation, the money
loses its role as store of value,
unit of account and medium of
exchange.
Bartering or using
commodity
money
becomes
prevalent.
In 1920s (1922-12/1923) Weimar

*Expected inflation: depends on

expectation of individuals about gp
in the future. Its impacts is small
but help to adjust production cost.

+Unexpected
inflation:
derives
from
exogenous
shocks
and
unexpected
factors
inside
economy.

The inconvenience of reducing money

holding is metaphorically called the
shoe-leather cost of inflation, because
walking to the bank more often induces
ones shoes to wear out more quickly.
When changes in inflation require printing
and distributing new pricing information,
then, these costs are called menu costs.
Another cost is related to tax laws. Often
tax laws do not take into consideration
inflationary effects on income.

Unanticipated inflation is unfavorable because it arbitrarily

redistributes wealth among individuals.
For example, it hurts individuals on fixed pensions. Often these
contracts were not created in real terms by being indexed to a
particular measure of the price level.
There is a benefit of inflation many economists say that some
inflation may make labor markets work better. They say it
greases the wheels of labor markets.

3. Causes of inflation
Demand-pull inflation
is
caused
by
continuing rises in AD
in the economy. The
increase in AD may be
caused
by
either
increases
in
the
money
supply
or
increases
in
Gexpenditure when the
economy is close to
full employment. In
general, demand-pull

P
AS

P1
AD1
P0
AD0
0

Y*

* Cost-push inflation is associated

with continuing rises in costs. Rises
in costs may originate from a
number of different sources such as
wage increases and other higher
costs
of
production
(e.g.
raw
P
AS
materials).
AS
1
0

P
P
1
0
0

AD
Y1 Y0 Y*

*Structural
(demand-shift)
inflation arises when the pattern
of demand (or supply) changes in
the economy which results I n
some
industries
experiencing
increased demand whilst others
experience decreased demand. If
prices
and
wage
rates
are
inflexible
downwards
in
the
contracting industries, and prices
and wage rates rise in the
expanding industries, the overall
price and wage level will rise. The
problem will be made worse, the

*Expectations
are
crucial
determinants of inflation. Workers
and firms take account of the
expected rate of inflation when
making decisions. Generally, the
higher the expected rate of
inflation, the higher will be the
level of pay settlements and price
rises, and hence the higher will be
the resulting actual rate of
inflation.

The quantity theory of money states that the central bank, which
controls the money supply, has the ultimate control over the
inflation rate. If the central bank keeps the money supply stable, the
price level will be stable. If the central bank increases the money
supply rapidly, the price level will rise rapidly.

4.Policies to deal with inflation:

4.1.Fiscal
policy
comprises
changes
in
government
expenditure and/or taxation. The
aim is to affect the level of AD
through a policy known as
demand management. In the
case of controlling inflation, this
involves reducing government
expenditure and/or increasing
taxation in what is called a
deflationary fiscal policy. Such
policies are likely to be effective
if inflation has been diagnosed

4.2.Monetary policy is concerned

with
influencing
the
money
supply and the interest rate. In
terms of controlling inflation, the
government can aim to reduce
the money supply thus reducing
spending and, therefore, the
aggregate demand, or it can
increase the interest rate so as to
increase the cost of borrowing.
Both policies can be seen as
deflationary
monetary
policy.
Since
monetarists
view
the
growth of the money supply as
being the main cause of inflation,

4.3.Prices and incomes policy aim

to limit and, in certain cases,
freeze wage and price increases.
In the past they have either been
statutory or voluntary. Statutory
prices and incomes policies have
to be enforced by government
legislation,
such
as
the
EU
minimum wage legislation. With a
voluntary prices and incomes
policy the government aims to
control
prices
and
incomes
through
voluntary
restraint,
possibly by obtaining the support

4.4.
Supply-side
policy
is
concerned
with
instituting
measures aimed at shifting the
aggregate supply curve to the
right. Supply-side economics is the
use of microeconomic incentives
to
alter
the
level
of
full
employment and the level of
potential output in the economy. If
inflation is caused by cost-push
pressures, supply-side policy can
help
to
reduce
these
cost
pressures in two ways:

(1) by reducing the power of trade

unions and/or firms (e.g. by antimonopoly legislation) and thereby
encouraging more competition in
the supply of labour and/or goods,
(2) by encouraging increases in
productivity
through
the
retraining
of
labour,
or
by
investment grants to firms, or by
tax incentives, etc.

4.5.Learning to live with inflation

involves accepting the fact that
inflation is here to stay when
standard anti inflationary policy
measures appear ineffective. In
such a situation we just have to
learn to live with inflation.
Learning to live with inflation
involves
the
government,
employers and workers taking
inflation into account in their
everyday
transactions.
For
example,
the
government/employers may use
indexation
in
wage/pensions
contracts. Indexation is when