Supply of Money Interest Rate the annual rate at which payment is made for the use of money (or borrowed funds) a percentage of the borrowed amount the price of money © 2012 McGraw-Hill Ryerson Limited9- 1 LO1

Supply of Money The supply of money is determined by the Bank of Canada © 2012 McGraw-Hill Ryerson Limited9- 2 LO1 Rate of interest Quantity of money MS the supply of money is constant at any one point in time

The Bank of Canada Canada’s central bank Government owned institution Directors and governor are appointed by the federal cabinet Current governor Mark Carney LO1 9- 3© 2012 McGraw-Hill Ryerson Limited

Functions of the Bank of Canada The issuer of currency The government’s bank and manager of foreign currency reserves The bankers’ bank and lender of last resort The auditor and inspector of commercial banks The regulator of the money supply LO1 9- 4© 2012 McGraw-Hill Ryerson Limited

Demand for Money Made up of 2 types of demand: 1.Transactions demand for money – The desire to hold money as a medium of exchange, that is, to effect transactions – The major determinants are the level of real income and the level of prices 2.Asset demand for money – The desire to use money as a store of wealth, that is, to hold money as an asset – The major determinant is the rate of interest LO1 9- 5© 2012 McGraw-Hill Ryerson Limited

Transactions Demand © 2012 McGraw-Hill Ryerson Limited9- 6 LO1 Transactions demand is unrelated to the rate of interest r Quantity of Money MD T r1r1 r2r2 Q

Asset Demand © 2012 McGraw-Hill Ryerson Limited9- 7 LO1 There is an inverse relationship between asset demand and the rate of interest r Q of Money r1r1 Q1Q1 r2r2 Q2Q2 MD A

Money Demand © 2012 McGraw-Hill Ryerson Limited9- 8 LO1 Total demand for money is the sum of transactions demand + asset demand r Q of Money MD= MD T + MD A MD T MD A

Demand for Money Determined by: 1.The level of transactions (real GDP) 2.The average value of transactions (the price level) 3.The rate of interest LO1 9- 9© 2012 McGraw-Hill Ryerson Limited

Equilibrium LO © 2012 McGraw-Hill Ryerson Limited Shortage MS MD Q of MQ1Q1 r1r1 r2r2 r3r3 Surplus At equilibrium interest rate, r1, there is no surplus or shortage of money. At any other rate there is either a shortage or surplus. At equilibrium interest rate, r1, there is no surplus or shortage of money. At any other rate there is either a shortage or surplus.

Self-Test 1 a) Assume that the nominal GDP in this economy is $800 and that the transaction demand for money is equal to 10 percent of nominal GDP. Draw in the total demand for money curve. b)If the money supply is $150 billion, draw in the money supply curve. c)If the interest rate, is 10 percent, is there a surplus or shortage of money? How much? © 2012 McGraw-Hill Ryerson Limited LO1 9-11

Self-Test 1 a) Assume that the nominal GDP in this economy is $800 and that the transaction demand for money is equal to 10 percent of nominal GDP. Draw in the total demand for money curve. © 2012 McGraw-Hill Ryerson Limited LO Interest rateAsset Demand ($billions) Transaction Demand MD

Self-Test 1 a) Assume that the nominal GDP in this economy is $800 and that the transaction demand for money is equal to 10 percent of nominal GDP. Draw in the total demand for money curve. b)If the money supply is $150 billion, draw in the money supply curve. © 2012 McGraw-Hill Ryerson Limited LO Q i S % 12% 6% D

Self-Test 1 c) If the interest rate is 10 percent, is there a surplus or shortage of money? How much? © 2012 McGraw-Hill Ryerson Limited LO Q i S % 12% 6% D

How the Money Market Adjusts – Money markets adjust to a surplus or shortage through bond yields – People can hold wealth as either money or bonds – Surplus of money: people buy bonds – Shortage of money: people sell bonds LO © 2012 McGraw-Hill Ryerson Limited

Bond Yields Bonds – Loans for a set period of time – Issued by corporations, banks, and various levels of government – Have a set face value – Pay a fixed rate of interest (the coupon rate) – Can be bought and sold in the market LO © 2012 McGraw-Hill Ryerson Limited

Bond Yields Bonds: -The return (“yield”) on a bond depends on: 1. the coupon rate 2. the profit or loss on its sale -Bond prices adjust to reflect return on other financial instruments with similar risk -The higher the price, the lower the return LO © 2012 McGraw-Hill Ryerson Limited

Bond Yields Example: $5000 bond, 4% coupon rate, 1 year -The higher the price, the lower the yield -The lower the price, the higher the yield LO © 2012 McGraw-Hill Ryerson Limited

How the Money Market Adjusts Surplus of money – People choose to buy bonds to reduce their liquidity and earn income – Bond prices rise, leading to a fall in bond yields and interest rates – Rates fall until there is no more surplus LO © 2012 McGraw-Hill Ryerson Limited

How the Money Market Adjusts Shortage of money – People sell bonds in order to increase their liquidity – Bond prices fall, leading to an increase in bond yields and interest rates – Rates increase until there is no more shortage LO © 2012 McGraw-Hill Ryerson Limited

How the Money Market Adjusts Increase in interest rate caused by: – Rise in the demand for money OR – Fall in the supply of money Decrease in interest rate caused by: – Fall in the demand for money OR – Rise in the supply of money LO © 2012 McGraw-Hill Ryerson Limited

Self-Test 2 a) If money supply = $150, what is the equilibrium interest rate? b)If money supply = $140, what is the equilibrium interest rate? c)If interest is 11% and MS = $150, what are the implications? © 2012 McGraw-Hill Ryerson Limited LO Interest rateAsset Demand ($billions) Transaction Demand MD

Self-Test 2 a) If money supply = $150, what is the equilibrium interest rate? b)If money supply = $140, what is the equilibrium interest rate? © 2012 McGraw-Hill Ryerson Limited LO Interest rateAsset Demand ($billions) Transaction Demand MD

Self-Test 2 c)If interest is 11% and MS = $150, what are the implications? © 2012 McGraw-Hill Ryerson Limited LO Interest rateAsset Demand ($billions) Transaction Demand MD

Self-Test 4 Show the effects if the Bank of Canada buys $2 billion worth of securities directly from the commercial banks. © 2012 McGraw-Hill Ryerson Limited LO All Commercial Banks ASSETS Reserves: in vaults$ 70 on deposit at B of C 12 Securities 118 Loans 600 Total assets$ 800 LIABILITIES Deposits 800 Total liabilities$ 800 Bank of Canada ASSETS T-bills and bonds$ 82 Total assets$ 82 LIABILITIES Notes in circulation$ 65 Deposits of banks 12 Other liabilities 5 Total liabilities$ 82

Self-Test 10 a)If M is $100, P is $2, and Q is 500, what is the velocity of money? b)Given the same parameters as in a), if the velocity of money stays constant and assuming the economy is at full employment, what will be the level of P if M increases to $120? © 2012 McGraw-Hill Ryerson Limited LO1 9-26