1. Start of M28
Why are products more expensive at convenience stores?

2. Module 28: The Money Market

3. MONEY Who has cash on them today? Why do you have cash?
Why would you have more money in your pocket today than you had yesterday?
What else could you do with your money? Save it
What would convince you to save that money?

4. Opportunity Cost of Holding Money
What is the price of the convenience to make purchases?
Suppose you could put $100 in a 12 month CD that would earn 5%. What is the cost of holding $100 in your pocket instead of in the CD?
50%?
0.5%?
That is what is the price of holding money in your pocket?
5% - $5
What if the interest rate was 50%? Would you still hold the cash? 0.5%?

5. Key Takeaway
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.
Long-term rates?
We don’t consider long term because we hold money to make purchases in the short-term.
We must consider the opportunity cost in the short-term, not the long-term.

6. The Money Demand Curve
Purchases are made in the short term – therefore the opp cost of holding money is the short-term interest rate.
In the short term there is no inflation – nominal = real interest rate
The Money Market graph shows the nominal interest rate on the y-axis.
You need to be able to recreate this graph – putting the real interest rate on the y-axis will result in lost marks.
As the interest rate rises, the opportunity cost of holding money does as well, so the qd of money falls

7. Demand for money functions like the demand for avocados.
It can shift due to external factors.
What would lead you to demand more avocados? (income, # of buyers, t&p, related goods, etc.)
Now how about money? – PL, RGDP, Technology, Institutions

8. Shifts of the MD Curve Changes in the Aggregate Price Level
Changes in Real GDP
Changes in Technology
Changes in Institutions
Any external change that makes holding money in your pocket more desirable at any interest rate will cause the demand curve for money to shift to the right.

9. Shifts of the MD Curve Aggregate Price Level
Higher prices increases demand for money.
The demand for money is proportional to the price level.
If the aggregate price level rises by 20%, it takes 20% more money buy the same goods.

10. Shifts of the MD Curve
2. Changes in Real GDP 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.
The more we buy, the more money we need.
As GDP rises so does income and expenditure.
GDP is the total amount of goods produced and sold in an economy.

11. Shifts of the MD Curve
3. Changes in Technology Advances in technology tend to reduce the demand for money by making it easier for the public to make purchases without holding significant sums of money (think ATM).

12. Shifts of the MD Curve
4. Changes in Institutions If the banking system becomes (or appears to be) unstable, the demand for money will increase.

13. Equilibrium Interest Rate
Money supply is determined by the Fed at any given point in time and is fixed.
We will soon learn how they control it.

14. Monetary Policy Three tools the Fed uses to conduct Monetary Policy:
Reserve Requirement
Discount Rate
Open-market Operations* 1

15. Monetary Policy
Recessionary Gaps require Expansionary Monetary Policy to…
>Increase Money Supply, decrease interest rates, increase Investment, increase Aggregate Demand
Inflationary Gaps require Contractionary Monetary Policy to…
>Decrease Money Supply, increase interest rates, decrease Investment, decrease Aggregate Demand

16. Liquidity Preference Model aka. Money Market
This model helps us reason about how the interest rate is determined by the supply and demand of money (why we come to an equilibrium interest rate).

17. Equilibrium Interest Rate
Think of it as if you can only put your money in two places – CDs, or your pocket.
If interest rate is above i* … Qms > Qmd --- high interest rates mean CD’s are attractive savings options, banks lower i until equilibirum
If interest rate is below i* … Q md > Qms --- CDs are not very attractive saving options because of low interest rates --- banks raise I until equilibrium
Above and below i*

18. M28 Summary
People hold (demand) money (think M1) primarily to make transactions. The other alternative is to save money in interest-bearing assets. When money is held as M1, earned interest is forgone, thus the short-term (or nominal) interest rate is the opportunity cost of holding money.
As the nominal interest rate rises, the opportunity cost of money rises, so the quantity of money held (demanded) falls. Thus the money demand curve is sloping downward with the nominal interest rate plotted on the vertical axis.

19. M28 Summary
Money demand will shift to the right if: the aggregate price level rises, real GDP rises, technology is slow to improve, and if banking systems become less reliable. Vice versa applies.
The liquidity preference model of the interest rate says that the nominal interest rate is determined by the intersection of the supply and demand for money in the market for money.
The model assumes that the supply of money is vertical, and chosen by the Fed, and that the demand for money is downward sloping
Bank runs, work sheets,

20. Review Question
Suppose RGDP is $2 trillion and potential GDP is $1.5 trillion. What open market operation could the central bank use to close the gap? How much would the open market operation need to be if the reserve requirement was 10%?

21. RGDP > Yp therefore inflationary gap
RGDP > Yp therefore inflationary gap. Inflationary gap requires a leftward shift of the AD curve. Decreasing the money supply with shift the AD curve left. Selling T-Bills decreases the money supply, How much should the central banks sell? MM = 1/0.1 = billion = x*10 500/10 = $ 50 billion Therefore to close an inflationary gap of $0.5 trillion ($500 billion) the central bank should sell $50 billion in T-Bills.

22. Liquidity Preference Model of the Interest Rate
Money supply is determined by the Fed at any given point in time and is fixed.
Think of it as if you can only put your money in two places – Cds, or your pocket.
If interest rate is above i* … Qms > Qmd --- high interest rates mean CD’s are attractive savings options, banks lower i until equilibirum
If interest rate is below i* … Q md > Qms --- CDs are not very attractive saving options because of low interest rates --- banks raise I until equilibrium
Above and below i*

23. Module 29: The Loanable Funds Market

24. Savings-Investment Identity
In a closed economy:
S=I
Add the public sector:
National Savings = I
(Private Savings + Public Savings) = I
Add the foreign sector:
National Savings + Capital Inflow = I
Remember

25. It is through financial markets that the funds of the savers are borrowed by investors.
Economists use the market for loanable funds to explain these interactions and determine the equilibrium real interest rate.

26. The Equilibrium Interest Rate
If you have money to save, where can you put it? Simplified Model > one market that brings together those who want to lend money and those who want to borrow. This is the Market for Loanable Funds

27. Market for Loanable Funds
Real interest rate on y axis OR
Nominal interest rate for a given future expected inflation rate
If expected inflation
Label it r

28. Liquidity Preference Model of the Interest Rate
Nominal interest rate on y axis
Labe it i

29. Remember..
Real Interest rate =
Nominal interest rate - inflation

30. Real and Nominal Interest Rates
If inflation = 0 … then the Real interest rate = If expected inflation is constant … then any change in the nominal rate will be reflected in an identical change in the real rate.
This is why in your text you will see the y axis labelled as “nominal interest rate for a given rate of future expected inflation rate”

31. Breaking Down the Graph

32. Demand for Loanable Funds
Demand comes from firms looking to borrow money to pay for capital investment projects.
If the project has an expected rate of return that is higher than the real interest rate, the investment will be profitable and the funds will be demanded.
This is why the demand for loanable funds is downward sloping.

33. Demand for Loanable Funds

34. Rate of Return Rate of Return (%)
= (Revenue from project – cost of project) *100
(cost of project)
As the real rate falls, so does the cost of the project, and more projects will become profitable.
Projects that have a rate of return higher than the interest rate will be profitable.

35. The Supply of Loanable Funds
Savers can lend their money to borrowers, but in doing so must forego consumption.
Savers receive interest income to compensate for foregone consumption.
As the real interest rate rises, the opportunity cost of spending today rises, and more money will be saved.
As the real interest rate rises, the quantity of funds supplied will increase.

36. Supply of Loanable Funds

37. Equilibrium in the Loanable Funds Market

38. Shifts in the Market Both Demand and Supply can shift. Demand
Changes in Perceived Business Opportunities
Changes in Government Borrowing
Supply
Changes in Private Saving Behaviour
Changes in Capital Inflows

39. Wednesday’s lecture ended here
Wednesday’s lecture ended here. Check out the slides below for the end of M29 material. We will review it further on Friday.

40. Crowding Out Effect
When the gov’t runs a budget deficit, the treasury must borrow funds. This increases the demand for loanable funds, and in effect, increases the equilibirum interest rate. When this occurs, fewer investment projects will be profitable, so I will decrease. Why does a gov’t run a budget deficit? To counteract a recessionary gap, but if G increases, and I decreases, what will be the result?

41. Changes in Supply
Capital Flows

42. What about changes in inflation?

43. Inflation and Interest Rates
Fisher Effect: the expected real interest rate is unaffected by the change in expected future inflation.
An increase in expected future inflation drives up nominal interest rates, where each additional percentage point of expected future inflation drives up the nominal interest rate by 1 percentage point.

44. Inflation and Interest Rates
Key Takeaway: Both lenders and borrowers base their decisions on the expected real interest rate. As long as the level of inflation is expected, it does not affect the equilibrium quantity of loanable funds or the expected real interest rate, all it affects is the nominal interest rate.

45. Inflation and Interest Rates
Expected Inflation is 0%
Real interest rate = 5%
Loanable funds = F1 Dollars
What happens if the expected future inflation rate changes to 5%?
Both curves shift upwards = new equilibrium interest rate is 10% at F1 dollars

46. Reconciling the Two Models
According to the liquidity preference model, a fall in the interest rate results in an increase in I spending, and following that an increase in RGDP and Consumption
The increase in RGDP results in an increase in consumption AND savings (through the multiplier)
How much do savings rise? Because of the savings-investment identity we know that savings = investment
So a fall in the interest rate leads to higher investment spending, and the resulting increase in RGDP generates exactly enough additional savings to match the rise in investment spending.
After a fall in the interest rate, the quantity of savings supplied rises exactly enough to match the quantity of savings demanded

47. The Interest Rate in the Long Run
In the long run, changes in the money supply DO NOT affect the interest rate.
In the long run, aggregate price level will rise by the same proportion as the increase in the MS (due to the neutrality of money concept)
As the aggregate price level rises, so does the demand for money, result in a shift to the right, and a return to the original interest rate of R1
In the loanable funds market, the supply of loanable funds eventually shifts back as price and nominal wages rise.

48. The Interest Rate in the Long Run
In the long run the equilibrium interest rate matches the supply and demand for loanable funds that arise at potential output.