The Money Market and the Loanable Funds Market 1

The Demand for Money People are face with the decision to hold their wealth as money OR as interest bearing assets. Opportunity Cost of holding money? Forgone interest! 3 types of money demand (motives for holding money): 1.Transactions: To make purchases of goods and services 2.Precautionary: To serve as protection against an unexpected need 3.Speculative: To serve as a store of wealth (money for investment purposes) The Demand for money shows an inverse relationship between interest rates and the quantity of money demanded 1. What happens to the quantity demanded of money when interest rates increase? Quantity demanded falls because individuals would prefer to have interest earning assets instead 2. What happens to the quantity demanded when interest rates decrease? Quantity demanded increases. There is no incentive to convert cash into interest earning assets 2

Nominal Interest Rate Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money Inverse relationship between interest rates and the quantity of money demanded 3 The Demand for Money

Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money What happens if price level increase? 4 The Demand for Money D Money1 Money Demand Shifters 1.Changes in price level & real GDP 2.Changes in income 3.Changes in taxation that affects investment Nominal Interest Rate

200 D Money S Money The FED is a nonpartisan government office that sets and adjusts the money supply to adjust the economy This is called Monetary Policy. The U.S. Money Supply is set by the Federal Reserve System (FED) 5 The Supply for Money 20% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir)

If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. The surplus will cause the interest rate to fall to 2% Increasing the Money Supply Increase money supply Decreases interest rate Increases investment Increases AD DMDM SMSM 10% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) How does this affect AD? 250 S M1

If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The shortage will cause the interest rate to rise to 10% Decreasing the Money Supply Decrease money supply Increase interest rate Decrease investment Decrease AD DMDM SMSM 10% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) How does this affect AD? 150 S M1

Loanable Funds Market

Q: Is an interest rate of 50% good or bad? A: Bad for borrowers but good for lenders The loanable funds market brings together those who demand funds to borrow (Dlf) with those who want to lend by supplying funds (Slf) 4 Groups Demand and Supply Loanable Funds: 1.Consumers 2.Government 3.Foreigners 4.Businesses Demand- Inverse relationship between real interest rate and quantity loans demanded (negative slope)- more loans demanded at lower interest rates. Supply- Direct relationship between real interest rate and quantity loans supplied (positive slope) 9

Real Interest Rate 10 D Borrowers S Lenders Loanable Funds Market Quantity of Loans Q Loans rere At the equilibrium real interest rate the amount borrowers want to borrow equals the amount lenders want to lend.

11 Loanable Funds Market 1.Government reduces interest tax rate on interest income 2.Other actions by the FED… 1.Confident businesses 2.Changes in government borrowing/spending 3.Consumer concerns about future 4.Rising incomes Demand Shifters Supply Shifters