Money Market Equilibrium Lecture 3 Money Market Equilibrium

Interim Assessment Date: Sunday, April15th,2017 Time: 8:00am Venue: to be announced later… Format: 40 MCQ Coverage: Dr. Owoo’s and Dr. Quayefio’s lectures. Instruction: Answer on question paper

Today’s Class… Financial assets The price of bonds and the interest rate Monetary equilibrium and the equilibrium interest rate Monetary Policy and Interest Rates

Quick Recap Demand for Money Supply of Money

The Money Demand Curve Total quantity of money demanded(held) in the economy at each interest rate Movement along A change in the interest rate Shifts in the Money Demand Curve Change in money demand caused by something other than the interest rate Real income Price level

The Supply of Money Controlled by the Central Bank Doesn’t change with the interest rate Money supply curve Total quantity of money in the economy at each interest rate Vertical line

The Supply of Money Figure 4 The Supply of Money Money ($ billions) Interest Rate E 6% J 3% 1,000 1,400

The Supply of Money Rightward shift Leftward shift Open market purchases Inject reserves into the banking system, Leftward shift Open market sales Withdraw reserves

Financial Assets The wealth of households are held in many forms Money in wallet or bank accounts Short term securities such as treasury bills Long term bonds Real capital-farms, houses, family businesses Indirectly- equities- part ownership of companies

Financial Assets- Categories Ways of holding wealth can be broadly classified into three main categories: Assets that serve as a medium of exchange-paper money, coins and bank account deposits Other financial assets such as bonds earning a fixed rate of interest, that will yield a fixed money value at some future maturity date Claims on real capital-that is physical objects such as factories and machines

Equilibrium in the Money Market Occurs when Quantity of money people are holding Quantity supplied Is equal to the quantity of money people want to hold Quantity demanded Equilibrium: SS = DD of money All the money is being willingly held people are satisfied holding the money that they are actually holding What people are actually holding (SS) = What people are want to hold. How is this equilibrium reached?? What are the forces at play?

Detour: Bond Prices and Interest Rates Promise to pay back borrowed funds At a certain date in the future called ‘redemption date’ The time until the maturity date is called the term to maturity Some bonds, called perpetuities pay interest for ever but never the principal Some promise to make payments each month, each year or a certain period of time and then pay back a large sum at the end. Others may promise to make just one payment (eg. 1,3,5,10 yrs) from the date the bond is issued.

For example: If a Large corporation or government needs to borrow money, it will issue a new bond and sell it in the bond market place. The amount borrowed is equal to the price of the bond. How? A bond promises to pay its holder Ghc1000 exactly a year from today. Suppose you purchase this bond from its issuer for Ghc 800 It means that you are lending the issuer of the bond Ghc 800 and you will be paid back Ghc1000 at the end of the year You will be getting Ghc 200 more than you lent. So the interest rate will be :200/800=25%

Now what if instead of 800 you paid a price of 900 for this same bond? The bond still promises to pay 1000 one year from now so your annual interest payment now will be 100 which translates to 100/900=11%- which is lower The interest rate you earn on your bond depends entirely on the price of the bond. The higher the price, the lower the interest rate This relationship also holds for all types of bonds not just the simple one-time payment bonds In General: the more you pay for any bond, the lower your overall rate of return, or interest rate. There is an inverse relationship between bond price and interest rate

Money Market Equilibrium Figure 5 Money Market Equilibrium Money ($ billions) Interest Rate 6% 9% 3% Ms At a higher interest rate, an excess supply of money causes the interest rate to fall At the equilibrium interest rate of 6%, the public is content to hold the quantity of money it is actually holding At a lower interest rate, an excess demand for money causes the interest rate to rise E Md 600 1,000 1,600

Money Market Equilibrium People holding more money than they would want to hold Excess supply of money Money supply > Quantity demanded Excess demand for bonds (only two options for the individual- holding money or bonds. If people want to hold less money=> they want to hold more bonds. When there is an excess supply of money in the economy, there is also an excess demand for bonds. Amount of bonds demanded > amount supplied which will cause the price of bonds to rise and then the interest rate will begin to fall as long as there is excess money supply and excess demand for bonds

Money Market Equilibrium Excess demand of money People want to hold more money than they are currently holding Money supply < Quantity demanded Excess supply of bonds (If people want to hold more money then they want to hold less bonds Amount of bonds demanded < amount supplied If demand is less than supply, it pushes prices of bonds downwards which translates into higher interest rates.

What Happens When Things Change? The Central Bank wants to lower the interest rate- it does not just declare changes. It must change the equilibrium interest rate in the money market by changing the money supply. Open market purchases Increase the money supply Change the equilibrium interest rate

An Increase in the Money Supply Figure 6 An Increase in the Money Supply At point E, the money market is in equilibrium at an interest rate of 6 percent. To lower the interest rate, the CB could increase the money supply to $1,600 billion. Money ($ billions) Interest Rate 6% 3% The excess supply of money (and excess demand for bonds) would cause bond prices to rise, and the interest rate to fall until a new equilibrium is established at point F with an interest rate of 3 percent. E F Md 1,000 1,600

What Happens When Things Change? The CB - increase the interest rate Open market sales Decrease the money supply Change the equilibrium interest rate

Interest Rate Changes - Affect the Economy Central Bank increases the money supply, interest rate falls. How does this affect the economy? A boost in different types of spending: Spending increases plant and equipment(lower cost of borrowing) new housing consumer durables( cars,furniture etc..) Central Bank decreases the money supply Interest rate rises Spending falls

Monetary Policy Control or manipulation of money supply By the Central Bank To achieve a macroeconomic goal

Monetary Policy Figure 7 Monetary Policy and the Economy Money ($ billions) Interest Rate Real GDP ($ billions) Real Aggregate Expenditures ($ trillions) Ms1 1,000 Ms2 1,600 Md 45° AEr=3% F 10,000 6% A AEr=6% 3% B 8,000 E

Next Class… Mr. Kwame Mantey AD, AS and Macroeconomic Equilbirium