The Money Market AP Macro Mr. Warner

What you will learn in this Module: What is the money demand curve? Why does the liquidity preference model determine the interest rate in the short run?

The Opportunity Cost of Holding Money Note: ask the students why they would want to have money in their pockets. The answer seems simple, but it can be more complex than, “I have money in my pocket to buy things.”   What would cause you to have more money in your pocket today than you had yesterday? I need to buy more things today. Or things today are more expensive than they were yesterday. Indeed, people hold money so that they can buy things. Now ask the students what else you can do with your money. You can save it! And what would make you interested in saving it? A higher interest rate. This prepares the way to discuss the opportunity cost of holding money. It is convenient to hold money in your pocket because it allows you to conveniently make purchases. The price of that convenience is that money in your pocket earns no interest. Suppose you could put $100 in a 12-month CD that would earn 5%. A CD is not very liquid because if you withdraw the money before 12 months, you forfeit most of the interest. $100 in your pocket or in your checking account (M1) will come at an opportunity cost of 5% or $5. Maybe it is easy to pass up $5 to have the convenience of $100 in your pocket. What if the interest rate was 50%? Would you still hold $100 in your pocket when the cost is now $50? If the interest rate was 0.5%, how likely is it that you would you put the $100 in the CD? Not very. Intuitively, this reflects a general result: the higher the short­ -­ term interest rate, the higher the opportunity cost of holding money; the lower the short­ -­ term interest rate, the lower the opportunity cost of holding money. Why don’t we consider long-term interest rates like 10-year CD’s as the opportunity cost of holding money? Because we hold money to make transactions in the short term. Therefore we must consider the opportunity cost in the short term, not the long term. Why do you have money in your pocket? What would cause you to want to carry more money? What are you “giving up” when you hold money? Interest-rates Transactions/Precautions/Speculations

The Money Demand Curve Money Demand Short-term IR, nominal Since we demand money to make purchases in the short term, the opportunity cost of holding money is the short-term interest rate.   We assume that in a short period of time, there will be virtually no inflation, so the nominal interest rate is equal to the real interest rate. Note: it is this assumption that allows us to put the nominal interest rate on the vertical axis of graph of the money market. Students will lose points on the AP exam if they label this axis as the real interest rate. As discussed above, when the interest rate rises, the opportunity cost of holding money rises, so the quantity of money demanded will fall. The money demand curve is downward sloping. Money Demand Short-term IR, nominal Downward Slope Opportunity Cost

Shifts of the Money Demand Curve Just like there are external factors that shift the demand curve for pomegranates, there are external factors that shift the demand curve for money.   Note: stress to the students that, if an external change makes holding money in your pocket more desirable at any interest rate, the demand curve for money will shift rightward. The most important factors causing the money demand curve to shift are changes in the aggregate price level, changes in real GDP, changes in banking technology, and changes in banking institutions. 1. Changes in the Aggregate Price Level All else equal, higher prices increase the demand for money (a rightward shift of the MD curve), and lower prices reduce the demand for money (a leftward shift of the MD curve). We can actually be more specific than this: other things equal, the demand for money is proportional to the price level. That is, if the aggregate price level rises by 20%, the quantity of money demanded at any given interest rate, also rises by 20%. Why? Because if the price of everything rises by 20%, it takes 20% more money to buy the same basket of goods and services. 2. Changes in Real GDP As the economy gets stronger, real incomes and real GDP rise. The larger the quantity of goods and services we buy, the larger the quantity of money we will want to hold at any given interest rate. So an increase in real GDP—the total quantity of goods and services produced and sold in the economy—shifts the money demand curve rightward. 3. Changes in Technology Changes in technology can affect the demand for money. In general, advances in information technology have tended to reduce the demand for money by making it easier for the public to make purchases without holding significant sums of money. If there was an ATM machine on every corner and in every retail store and restaurant, there would be little need to hold money in your pocket. 4. Changes in Institutions Regulations that make it more attractive to keep money in banks will reduce the demand for money. If a nation’s political and banking systems became dangerously unstable, it might increase the demand for money because people would rather hoard their money than store it in institutions that might be falling apart. ∆ Technology ∆ Real GDP ∆ Institutions – stability, proliferation ∆ Price Level – proportional KEY – any change that makes you prefer to hold money

The Equilibrium Interest Rate We assume that the money supply MS is determined by the Fed and is fixed at any given point in time. It is also independent of the interest rate so it is depicted as a vertical line.   Note: To understand how the interest rate is determined, illustrate the liquidity preference model of the interest rate. This model says that the interest rate is determined by the supply and demand for money in the market for money. Note: it will be helpful to students if we think of only two places to put your money. You can put money in CDs that provide interest, or you can hold cash that earns no interest. Discuss equilibrium by discussing interest rates above and below i*. Case 1. What would happen to interest rates and the quantity of money demanded if there was some interest rate i1 that was greater than i*? If i1 > i*, the quantity of money supplied exceeds the quantity of money demanded. Why? Because of high interest rates, CDs are very attractive saving options! In fact, banks find that they can lower the interest rate on CDs and still have plenty of customers ready to buy a CD. As interest rates fall, the quantity of money demanded gets closer and closer to M*. Case 2. What would happen to interest rates and the quantity of money demanded if there was some interest rate i2 that was less than i*? If i2 < i*, the quantity of money demanded exceeds the quantity of money supplied. Why? Because of low interest rates, CDs are not very attractive saving options! In fact, banks find that they must raise the interest rate on CDs to get more customers ready to buy a CD. As interest rates rise, the quantity of money demanded gets closer and closer to M*. Liquidity Preference Model of the Interest Rate Money Supply CD vs. Cash

Two Models of the Interest Rate The model of liquidity preference describes equilibrium in the money market. This model is a good foundation for learning a similar market in loanable funds that is also useful in describing how interest rates are determined and the impact of monetary policy and other more advanced topics.

Play time Draw a correctly labeled money market graph Along the X mark in intervals of $10b, up to 70b. Along the Y mark in intervals of 1% up to 5%. What’s the supply of money in this economy necessary to put interest rates around 3%? What three courses of action could the fed use to increase interest rates by 1% to control inflation At 3%, if the reserve requirement is 10%, what is the size of the monetary base (assuming no leaks)? 7. If the fed buys $1 b. worth of securities, what is the change in the interest rate? The model of liquidity preference describes equilibrium in the money market. This model is a good foundation for learning a similar market in loanable funds that is also useful in describing how interest rates are determined and the impact of monetary policy and other more advanced topics.

Additional details Short term CD vs. Cash We assume that the money supply MS is determined by the Fed and is fixed at any given point in time. It is also independent of the interest rate so it is depicted as a vertical line.   Note: To understand how the interest rate is determined, illustrate the liquidity preference model of the interest rate. This model says that the interest rate is determined by the supply and demand for money in the market for money. Note: it will be helpful to students if we think of only two places to put your money. You can put money in CDs that provide interest, or you can hold cash that earns no interest. Discuss equilibrium by discussing interest rates above and below i*. Case 1. What would happen to interest rates and the quantity of money demanded if there was some interest rate i1 that was greater than i*? If i1 > i*, the quantity of money supplied exceeds the quantity of money demanded. Why? Because of high interest rates, CDs are very attractive saving options! In fact, banks find that they can lower the interest rate on CDs and still have plenty of customers ready to buy a CD. As interest rates fall, the quantity of money demanded gets closer and closer to M*. Case 2. What would happen to interest rates and the quantity of money demanded if there was some interest rate i2 that was less than i*? If i2 < i*, the quantity of money demanded exceeds the quantity of money supplied. Why? Because of low interest rates, CDs are not very attractive saving options! In fact, banks find that they must raise the interest rate on CDs to get more customers ready to buy a CD. As interest rates rise, the quantity of money demanded gets closer and closer to M*. Short term CD vs. Cash Any short term investment – stocks, bonds, etc.