Page 57 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes Y is full employment real income and is fixed in the model. Since Y is fixed, V is also
f f
unchanged. Because both Y and V are unchanged, M becomes a direct and proportional
f
function of P.
Example: If P changes by 10%, M also changes by 10%. It is because when P rises people
require more money to carry out transactions. So, higher the overall price level higher the
demand for money.

Supply of Money

The supply of money is determined by the monetary authorities of the countries. It is not
influenced by the change in the overall price level P. It is independent of P.

Determination of Overall Price Level

Given supply of money, the overall price level P is determined at that level at which people
decide to hold the entire money supply. P is determined where money supply equals demand
for money.
Refer to the Figure 3.21. The demand for money curve Dm is upward sloping and straight line
because there is a direct and proportional relation between Dm and P. Since the supply of money
is fixed and has nothing to do with P, the supply of money curve Sm is parallel to the y-axis. The
intersection of the Dm and Sm curves determines the price level at which the people will hold
the entire money supply OM . The price level is OPo.
o
Figure 3.21

Y
Price Sm
level
Dm

P
E

X
O M Quantity of money
Fig. 10.20
The effect of change in Dm and Sm
Since the P is determined by Dm and Sm, any change in Dm or Sm, can bring change in P.
Suppose Supply of Money Changes: Sm increases from OM to OM . (Figure 3.22). The Sm curve
o 1
shifts to the right. At OP people were holding OM of money. When supply of money increase
o o
to OM people are now holding more money at OP than that want to. The excess money holding
1 o
is EoA (=M M ). People will like to reduce holding.
o 1

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