Topic 7 The Money Market and the Interest Rate

The Demand For Money Demand for money does not mean how much money people would like to have. Rather, it means how much money people would like to hold, given constraints they face.

An Individual’s Demand for Money At any given moment, total amount of wealth we have is given Total wealth = Money + Other assets If we want to hold more wealth in form of money, we must hold less wealth in other assets So, an individual’s quantity of money demanded is the amount of wealth individual chooses to hold as money Why do people want to hold some of their wealth in form of money? Money is a means of payments Other forms of wealth provide a financial return to their owners Money pays either very little interest or none at all When you hold money, you bear an opportunity cost Interest you could have earned

An Individual’s Demand for Money Individuals choose how to divide wealth between two assets Money, which can be used as a means of payment but earns no interest Bonds, which earn interest, but cannot be used as a means of payment What determines how much money an individual will decide to hold? Price level Real income Interest rate

The Money Demand Curve Figure 1 - a money demand curve Tells us total quantity of money demanded in economy at each interest rate Curve is downward sloping As long as other influences on money demand don’t change A drop in interest rate—which lowers the opportunity cost of holding money—will increase quantity of money demanded

Figure 1: The Money Demand Curve

Shifts in the Money Demand Curve What happens when something other than interest rate changes quantity of money demanded? Curve shifts A change in interest rate moves us along money demand curve

Figure 2: A Shift in the Money Supply Curve

Figure 3: Shifts and Movements Along the Money Demand Curve—A Summary

The Supply of Money Money supply is determined by the Fed. And we assume that the quantity of money supplied is not related to interest rate. So, interest rate can rise or fall, but money supply will remain constant unless and until Fed decides to change it So, the relationship between interest rate and the quantity of money supplied can be described by a vertical line.

Change in Money Supply Open market purchases of bonds inject reserves into banking system Shift money supply curve rightward by a multiple of reserve injection Open market sales have the opposite effect Withdraw reserves from system Shift money supply curve leftward by a multiple of reserve withdrawal

Figure 4: The Supply of Money 700 M 2 s Money ($ Billions) Interest Rate 6% E J 500 3% 1

Figure 5: Money Market Equilibrium

How money market reaches an equilibrium? At a higher interest rate, supply of money is larger than demand of money At a lower interest rate, demand of money is larger than supply of money

How the Fed Changes the Interest Rate Fed officials cannot just declare that interest rate should be lower Fed must change the equilibrium interest rate in the money market Does this by changing money supply The process works like this Fed can raise interest rate as well, through open market sales of bonds

Figure 6: An Increase in the Money Supply

How the Interest Rate Affects Spending Lower interest rate stimulates business spending on plant and equipment Interest rate changes also affect spending on new houses and apartments that are built by developers or individuals Mortgage interest rates tend to rise and fall with other interest rates

How the Interest Rate Affects Spending Interest rate affects consumption spending on big ticket items Such as new cars, furniture, and dishwashers Economists call these consumer durables because they usually last several years Can summarize impact of money supply changes as follows When Fed increases money supply, interest rate falls, and spending on three categories of goods increases Plant and equipment New housing Consumer durables (especially automobiles) When Fed decreases money supply, interest rate rises, and these categories of spending fall

Monetary Policy and the Economy What happens when Fed conducts open market purchases of bonds What happens when Fed conducts open market sales of bonds

Figure 7(a): Monetary Policy and the Economy

Figure 7(b): Monetary Policy and the Economy

An Increase in Government Purchases What happens when government changes its fiscal policy Say, by increasing government purchases Increase in government purchases will set off multiplier process Shifting the aggregate expenditure upward Increasing GDP and income in each round But ,also sets in motion forces that shift AE downward As GDP rises, demand of money increases As demand of money increases, interest rate rises As interest rate becomes higher, consumption and investment spending decrease so that AE gets smaller

An Increase in Government Purchases Interest rate is an automatic stabilizer In short-run, increase in government purchases causes real GDP to rise But not by as much as if interest rate had not increased Aggregate expenditure line is higher, but by less than ΔG Real GDP and real income are higher But rise is less than [1/(1 – MPC)] x ΔG Money demand curve has shifted rightward Because real income is higher Interest rate is higher Because money demand has increased Autonomous consumption and investment spending are lower Because the interest rate is higher

An Increase in Government Purchases

Figure 8(a): Fiscal Policy and the Money Market

Figure 8(b): Fiscal Policy and the Money Market

Crowding Out Effect When effects in money market are included in short-run macro model An increase in government purchases raises interest rate and crowds out some private investment spending May also crowd out consumption spending In the classical model, an increase in government purchases causes complete crowding out so that the fiscal policy has no effect on potential GDP In short-run, however, conclusion is somewhat different Crowding out is not complete Investment spending falls, and consumption spending may fall, but together, they do not drop by as much as rise in government purchases In short-run, real GDP rises

Other Spending Changes Increases in G, IP, NX, and a, as well as decreases in taxes, all shift AE line upward Real GDP rises, but so does interest rate Rise in equilibrium GDP is smaller than if interest rate remained constant Decreases in G, IP, NX, and a, as well as increases in taxes, all shift AE line downward Real GDP falls, but so does interest rate Decline in equilibrium GDP is smaller than if interest rate remained constant

Expectations and the Money Market Important insight of money market analysis in this chapter There is an inverse relationship between a bond’s price and interest rate it earns for its holder Therefore, if people expect interest rate to fall, they must be expecting price of bonds to rise A general expectation that interest rates will rise (bond prices will fall) in the future will cause money demand curve to shift rightward in the present When public as a whole expects interest rate to rise (fall) in the future, they will drive up (down) interest rate in the present

Figure 9: Interest Rate Expectations