1. Chapter 4 Appendix 4 Supply and Demand in the Market for Money: The Liquidity Preference Framework

2. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-1 Liquidity Preference Framework Economy with two assets: ─ Money (M) – earns no interest ─ Bonds (B) – earn a fixed interest rate Supply and Demand for each: B s – B d = M d - M s

3. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-2 Liquidity Preference Framework Money supplied is assumed fixed Figure 1 shows quantity of money demanded, holding all other variables (income and price levels) constant.

4. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-3 Liquidity Preference Framework Figure 1 Equilibrium in the Market for Money

5. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-4 Changes in Equilibrium Interest Rates Shifts in the Demand for Money ─ Income effect – higher income increases demand ─ Price-Level effect – higher prices increase demand Shifts in the Supply of Money ─ Increase in M s will shift supply curve to the right

6. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-5 Changes in Interest Rates Due to Other Factors Table 1 Summary Factors That Shift the Demand for and Supply of Money

7. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-6 Changes in Interest Rates Due to Changes in Income Figure 2 Response to a Change in Income

8. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-7 Changes in Interest Rates Due to Changes in Price Level Figure 3 Response to a Change in the Price Level

9. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-8 Changes in Interest Rates Due to Changes in M s Figure 4 Response to a Change in the Money Supply

10. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-9 Are Money and Interest Rates Negatively Related? Last Figure seems to suggest that. We have seen the equilibrium effect of increases in other variables from an increase in the money supply: ─ income effect: rise in interest rates ─ price-level effect: rise in interest rates ─ excepted-inflation effect: rise in interest rates

11. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-10 Are Money and Interest Rates Negatively Related? Analysis is a bit more complicated! ─ price-level effect will develop as prices increase ─ inflation-effect ends as price-levels peak We can now put all the effects together depending on which effect dominates

12. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-11 Responses to Money Supply Growth (a) Figure 5 Response over Time to an Increase in Money Supply Growth

13. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-12 Responses to Money Supply Growth (b) Figure 5 Response over Time to an Increase in Money Supply Growth

14. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-13 Responses to Money Supply Growth (c) Figure 5 Response over Time to an Increase in Money Supply Growth

15. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-14 Are Money and Interest Rates Negatively Related? Which scenario is correct? A look at the actual movements of interest rates and money growth can offer some insight.

16. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-15 Money Growth and Interest Rates Figure 6 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2013

17. Copyright ©2015 Pearson Education, Inc. All rights reserved.4-16 Are Money and Interest Rates Negatively Related? What does Figure 6 tell us? ─ Figure 5 (a) is unlikely, money supply growth is usually accompanied by expected inflation ─ Can’t really say much about Figure 5 (b) or (c). Depends on expectations. Recent research does suggest that increased money growth temporarily lowers short-term interest rates.