Outline: Why agents wish to hold money The portfolio choice The demand for money Changes in the demand for money Bond prices and yields—why they move inversely The supply of money Equilibrium in the money market How the money market reaches equilibrium. Effects of FED open market operations.

To make transactions To be prepared for contingencies— accidents, lawsuits, e.g. To store wealth—as an alternative to bonds, equities, jewelry, farmland, etc.

The Portfolio Decision: Money or Bonds? Bonds yield interest; money does not. The opportunity cost of holding money is given by the interest that could have been earned by holding bonds. “Interest is the reward for parting with liquidity.”

The Demand for Money (MD) The demand for money (MD) depends on: The nominal interest rate The price level Real GDP Financial technology

MD is positively related to the price level and real GDP, ceteris paribus. Also, MD is inversely related to the nominal interest rate, ceteris paribus.

Nominal Interest Rate (%) Money ($Trillions) 0 MD E F 3% 6% Demand for Money As we move along MD, the price level and real GDP are held constant. The movement from point E to F is a change in the demand for money as a store of value in reaction to a decrease in the yield of bonds.

Nominal Interest Rate (%) Money ($Trillions) 0 MD 1 E F 3% 6% Effect of a Change in Price Level (P) or Real GDP (Y) MD MD 1  MD 2 Increase in P, ceteris paribus. Increase in Y, ceteris paribus G H

Bond Prices and the Rate Of Interest Bond prices and interest rates (or yields), move inversely

Suppose you paid $800 for a bond that promises to pay $1,000 to its holder one year from today. What is the interest rate or percentage yield of the bond? Notice first that your interest income would be equal to $200. Hence to compute the yield, use the following equation: Yield (%) = (interest income/price of the bond)  100 Thus, we have: Yield (%) = (200/800)  100 = 25 percent Now suppose, instead of paying $800 for the bond, you paid $900. What is the yield now? Yield (%) = (100/900)  100 = 11 percent

The supply of money schedule reveals the stock of money available to satisfy the demand for money at various nominal interest rates. We assume the supply of money is determined by the Federal Reserve system or the FED. The FED can change the money supply by adjusting reserve requirements, the discount rate, or by open market operations.

Money ($Trillions) 0 3% 6% Supply of Money (MS) J E MS 1 MS 2 M s 1  M s 2 Decrease of the required reserve ratio Decrease of discount rate Open market purchase of government securities Nominal Interest Rate (%)

Money ($Trillions) 0 3% 6% Equilibrium in the Money market E MS MD 7% 0.9 When r = 7%, MS > MD by $100 billion. When r = 3%, MD > MS by $400 billion. When r = 6%, MS = MD Nominal Interest Rate (%)

When there is an excess supply of money in the economy, there is also an excess demand for bonds Interest rate higher than equilibrium Excess supply of money Excess demand for bonds Public buys bonds Price of bonds rises

Money ($Billions) 0 MS 1 MS 2 MD E F 6% 4% FED open market purchases bid up the prices of bonds, and drive yields down. Open Market Operations and the Money Market Nominal Interest Rate (%)

Money ($Trillions) 0 MS 0 MS 1 MD E F 8% 6% Nominal Interest Rate (%) FED open market sales depress bond prices, and drives yields upward. Fed “Pulls the String”