Opportunity Cost of Money - holding money in your wallet earns no interest, but its more convenient than going to the ATM every time you need cash - earn more interest in certificates of deposit (CDs) than regular bank accounts, but CD’s charge a penalty if you withdraw funds early - short term interest rates- interest rates on financial assets that mature w/in less than one year - long term assets- interest rates mature after 1 year

The Money Market The market where the Fed and the users of money interact thus determining the nominal interest rate (i%). Money Demand (MD) comes from households, firms, government and the foreign sector. The Money Supply (MS) is determined only by the Federal Reserve.

Money Demand- Transaction Demand – demand for money as a medium of exchange (independent of the interest rate). Asset Demand – demand for money as a store of value (dependent on the interest rate). Total Money Demand – (MD) is downward sloping because at high interest rates people are less inclined to hold money and more inclined to hold stocks & bonds. At lower interest rates people sacrifice less when they hold money.

The Money Market The equilibrium of S M & D M determines the nominal interest rate (ir N ). D M is downward sloping because the nominal interest rate is the opportunity cost of holding money. S M is vertical because it is independent of the interest rate. ir N r QMQM SMSM DMDM Q

Money Demand Curve if ir opportunity cost of holding money leading the public to reduce the quantity of money it demands

Shifts in Money Demand –change in aggregate PL (takes more money to buy the same things, inflation) –change in rGDP (buy more which takes more money, income) –change in technology (credit/debit cards reduce the MD) –change in institutions (banking regulations)

Changes in Money Demand Money Demand is dependent on both the Price Level and Real GDP which together comprise the Nominal GDP –Nominal GDP↑.: D M →.: ir N ↑ –Nominal GDP↓.: D M ←.: ir N ↓ ir N r QMQM SMSM DMDM Q r1r1 D M1 → → ↑D M.: ir N ↑ ir N r QMQM SMSM DMDM Q r1r1 D M1 ← → ↓D M.: ir N ↓

Figure 2 An Increase in the Money Supply Quantity of Money Value of Money, 1/ P Price Level, P Money demand 0 1 (Low) (High) (Low) 1 / 2 1 / 4 3 / M1M1 MS 1 M2M2 MS decreases the value of mon e y and increase s the price level. 1. An increase in the money supply... A B

Money Supply, Money Demand, and Monetary Equilibrium The money supply is a policy variable that is controlled by the Fed inelastic Fed will set MS to achieve its target interest rate (monopoly control on money supply)

Changes in the Money Supply Only the Fed determines the money supply Contractionary Monetary Policy –↓S M.: ir N ↑ ir N r QMQM SMSM DMDM Q r1r1 SM1SM1 → → → Q1Q1 ↑S M.: ir N ↓ ir N r QMQM SMSM DMDM Q r1r1 SM1SM1 ← ← → Q1Q1 ↓S M.: ir N ↑ Expansionary Monetary Policy ↑S M.: ir N ↓

How the Supply and Demand for Money Determine the Equilibrium Price Level Quantity of Money Value of Money, 1/ P Price Level, P Quantity fixed by the Fed Money supply 0 1 (Low) (High) (Low) 1 / 2 1 / 4 3 / Equilibriu m value of mone y Equilibriu m price level Money demand A

Nominal Interest Rate % 7.5% 5% DmDm E MS 1 Money Market At a 7.5% interest rate, the amount of money in circulation is more than households and firms wish to hold. They will attempt to reduce their money holdings by buying bonds. Billion [at “E”, money supplied ($200) = money demanded ($200)] Excess supply of money

At 2.5 %, households don’t have enough money to facilitate ordinary transactions. They will sell bonds and put the money in their checking accounts. Nominal Interest Rate DmDm E MS 1 [at “E”, money supplied ($200) = money demanded ($200)] Money Market Billion Excess demand for money Excess supply of money

Interest rates are important in explaining economic behavior Using a correctly labeled graph of the money market, show how an increase in the income level will affect the nominal interest rates in the short run Using a correctly labeled graph of the loanable funds market, show how a decision by households to increase savings for retirement will affect the real inter rate in the short run. Suppose that the nominal interest rate has been 6 percent with no expected inflation. If inflation is now expected to be 2 percent, determine the value of each of the following. –The new nominal interest rate –The new real interest rate

The Market for Loanable Funds Financial markets coordinate the economy’s saving and investment in the market for loanable funds. Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.

Market for Loanable Funds - Hypothetical market illustrating market income of demand for funds generated by borrowers and supply of funds from lenders - Comprises stock and bond market - Have to use nominal rate because you can’t know inflation rate - Assume only one type of loan

The market where savers and borrowers exchange funds (Q LF ) at the real rate of interest (ir R ). rate of return= (revenue from project-cost of project) cost of project - loan only when rate of return is greater or equal to interest rate - ir QD (higher return for savers) - ir QS (higher return for lenders) - match desired savings with desired investment spending 1) right investments get made (have higher rates of return) 2) savers are willing to lend for lower rates (efficient use of savings) Loanable Funds Market in Equilibrium x 100

Loanable Funds Market in Equilibrium ir R QLFQLF S LF D LF r q

Loanable Funds Market The demand for loanable funds, or borrowing comes from households, firms, government and the foreign sector. The supply of loanable funds, or savings comes from households, firms, government and the foreign sector.

Changes in the Demand for Loanable Funds Remember that demand for loanable funds = borrowing More borrowing = more demand for loanable funds (shift right) Less borrowing = less demand for loanable funds (shift left) Examples –Government deficit spending = more borrowing = more demand for loanable funds.: D LF shift right.: ir R ↑ –Less investment demand = less borrowing = less demand for loanable funds.: D LF shift left.: ir R ↓

- change in perceived business opportunities - change in gov’t borrowing (gov’t in deficit are major sources of demand for loanable funds) crowding out- gov’t deficit drives up interest rate and leads to reduced investment spending - change in private saving behavior (feeling richer) - change in capital inflows (foreign investment)

Increase in the Demand for Loanable Funds ir R QLFQLF SLFSLF DLFDLF r q D LF 1 r1r1 q 1 D LF shift right.: ir R ↑ & Q LF ↑

S2S2 1. Tax incentives for saving increase the supply of loanable funds... An Increase in the Supply of Loanable Funds... Loanable Funds (in billions of dollars) 0 Interest Rate 5% Supply, S 1 $1,200 Demand $1, and raises the equilibrium quantity of loanable funds. 4% 2....which reduces the equilibrium interest rate... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Decrease in the Demand for Loanable Funds ir R QLFQLF SLFSLF D LF 1 r1r1 q1q1 DLFDLF r q D LF shift left.: ir R ↓ & Q LF ↓

Decrease in the Supply of Loanable Funds ir R QLFQLF SLFSLF DLFDLF r q S LF shift left.: ir R ↑ & Q LF ↓ S LF 1 r1r1 q1q1

Changes in the Supply of Loanable Funds Remember that supply of LF = saving More saving = more supply of LF (shift right) Less saving = less supply of LF (shift left) Examples –Government budget surplus = more saving = more supply of loanable funds.: S LF shift right.: ir R ↓ –Decrease in consumers’ MPS = less saving = less supply of loanable funds.: S LF shift left.: ir R ↑

Crowding Out When the government deficit spends… –D LF increases –ir R rise What does that mean for business firms? –They won’t borrow as much because ir R are high So… – D LF ir R I

Taxes and Saving Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.

Taxes and Saving A tax decrease increases the incentive for households to save at any given interest rate.  The supply of loanable funds curve shifts to the right.  The equilibrium interest rate decreases.  The quantity demanded for loanable funds increases.

Taxes and Saving If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment. If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

Taxes and Investment An investment tax credit increases the incentive to borrow.  Increases the demand for loanable funds.  Shifts the demand curve to the right.  Results in a higher interest rate and a greater quantity saved.

Government Budget Deficits and Surpluses When government reduces national saving by running a deficit, the interest rate rises and investment falls. A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

S2S2 1. A budget deficit decreases the supply of loanable funds... The Effect of a Government Budget Deficit... Loanable Funds (in billions of dollars) 0 Interest Rate $1,200 Supply, S 1 Demand 5% $ and reduces the equilibrium quantity of loanable funds which raises the equilibrium interest rate... 6% Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Summary The interest rate is determined by the supply and demand for loanable funds. The supply of loanable funds comes from households who want to save some of their income. The demand for loanable funds comes from households and firms who want to borrow for investment.

Summary National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.

ir R QLFQLF SLFSLF DLFDLF r q D LF 1 r1r1 q 1 G↑ and/or T↓.: Government deficit spends.: D LF shift right.: ir R ↑.: I G ↓ (Crowding-Out Effect) Effect of Expansionary Fiscal Policy on Loanable Funds & Investment ir R IGIG IDID I I1I1

The Effects of a Monetary Injection The Quantity Theory of Money –How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the economy determines the value of money. The primary cause of inflation is the growth in the quantity of money.

Velocity and the Quantity Equation The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. V = (P × Y)/M where: V = velocity P = the price level Y = the quantity of output M = the quantity of money

The Fisher Effect The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate. According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same. Lenders and borrowers base their decisions on expected inflation As long as level of inflation is expected, it doesn’t affect equilibrium quantity of loanable funds or expected rir