An Introduction to Demand Management, Long-Run Growth and Global Economic Governance
Chapter 7: Money Matters! The LM Curve and Money Market Equilibrium
In January 2002, I received a shocking payment slip on which my salary was suddenly less than half the level of the previous month. The reason was not that I had done a bad job, but that the euro had been introduced overnight at a fixed exchange rate of 2.2 guilders to the euro. Fortunately for me, all prices of course also decreased by the same percentage. Therefore, if a car had cost 22,000 guilders before the introduction of the euro it would cost €10,000 after the introduction of the euro. Nothing had really changed because all prices were now also expressed in euro (and thus divided by 2.2) and the same was true for my mortgage and my saving account. Indeed, while my income was more than halved it did not matter because all prices (of goods and services and the factors of production) and the valuation of my debts and assets changed in the same way. The only thing that had changed was the amount of money that I had to keep in my purse. I always carried some 110 guilders in notes with me and this changed to 50 euro. My nominal money demand thus reduced from 110 to 50, but I could buy exactly the same amount of goods and services. If people do not suffer from money illusion, they will recognize these basic economic principles. An increase in the nominal value that is matched by the same increase in the general price level does not make a real change. In the long run people do not suffer from money illusion and this is why we will use the real money demand in our discussion.
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