Walras’’ Law

Walras
In an economy of n markets, when (n –1) markets clear,
the nth market will also be in equilibrium
equilibrium.
bonds, (MS + BS), must be
Therefore, total supply of money and bonds,
equal to the total demand for money and bondsbonds,, (MD + BD), since
people who are trying to sell bonds are trying to obtain money
money..

Hence, MS + BS = MD + BD
or (MD – MS) + (BD – BS) = 0

If there is an excess demand for money, there must

be an excess supply of bonds.

SB/Macro
 Money Demand and Income

Money
Demand

kY

0 Income

SB/Macro
Money Demand and Interest Rate

SB/Macro
 Keynesian Theory of Money Demand
The Precautionary Motive

• Cash balances held in case of unforeseen outlays, essentially

of a transaction nature (e.g., unforeseen medical bill).

• People hold money because they can't anticipate every need,

there is uncertainty, so they would like to hold more.
more

SB/Macro
 Keynesian Theory of Speculative Demand for Money

• Speculation = buying an asset in the hopes that its price will

rise, e.g., a bond.
• Bond price varies inversely with interest rate, i.e., if interest
rate rises, bond price falls.

Lower the interest rate, lower the interest income from

bonds, hence people would like to hold fewer bonds.

SB/Macro
 Equilibrium Interest Rate
Combining demand for money with supply of money

I
Ms controlled by RBI
N
T
E
R
E
Stable eqlbn.
S
T

R
A
T
E
Md

0 M

SB/Macro
Expand supply of money to decrease interest rate

Interest rate
Ms controlled by RBI

↑ Ms ⇒ ↓ interest rate

Md
M

SB/Macro
Contract supply of money to increase interest rate

Interest
Rate
Ms

↓ Ms ⇒ ↑ interest rate

Md

0 M

SB/Macro
• Tight monetary policy refers to the RBI policies that
contract the money supply in an effort to restrain the
economy.

• Easy monetary policy refers to the RBI policies that

expand the money supply in an effort to stimulate the
economy.

SB/Macro
 The Classical View
The Quantity Theory of Money

MS × V = P × Y
Money Supply × Velocity† = Price × Output
Classicists assumed V and Y to be fixed.

Therefore, price level is proportional to the money stock

stock..

† It measures the rate at which money circulates in the economy

economy.

SB/Macro
Thus, the classical QTM states that the Central Bank,
which controls the money supply, has ultimate control
over inflation.

If the Central Bank keeps the money supply stable,

then price level will be stable
stable.. If the Central Bank
increases the money supply rapidly, the price level
will rise rapidly.

SB/Macro