1. Money Market Equilibrium
Lecture 3
Money Market Equilibrium

2. Interim Assessment Date: Sunday, April15th,2017 Time: 8:00am
Venue: to be announced later…
Format: 40 MCQ
Coverage: Dr. Owoo’s and Dr. Quayefio’s lectures.
Instruction: Answer on question paper

3. Today’s Class… Financial assets
The price of bonds and the interest rate
Monetary equilibrium and the equilibrium interest rate
Monetary Policy and Interest Rates

4. Quick Recap
Demand for Money
Supply of Money

5. The Money Demand Curve
Total quantity of money demanded(held) in the economy at each interest rate
Movement along
A change in the interest rate
Shifts in the Money Demand Curve
Change in money demand caused by something other than the interest rate
Real income
Price level

6. The Supply of Money Controlled by the Central Bank
Doesn’t change with the interest rate
Money supply curve
Total quantity of money in the economy at each interest rate
Vertical line

7. The Supply of Money Figure 4 The Supply of Money Money ($ billions)
Interest Rate E 6% J 3%
1,000
1,400

8. The Supply of Money Rightward shift Leftward shift
Open market purchases
Inject reserves into the banking system,
Leftward shift
Open market sales
Withdraw reserves

9. Financial Assets The wealth of households are held in many forms
Money in wallet or bank accounts
Short term securities such as treasury bills
Long term bonds
Real capital-farms, houses, family businesses
Indirectly- equities- part ownership of companies

10. Financial Assets- Categories
Ways of holding wealth can be broadly classified into three main categories:
Assets that serve as a medium of exchange-paper money, coins and bank account deposits
Other financial assets such as bonds earning a fixed rate of interest, that will yield a fixed money value at some future maturity date
Claims on real capital-that is physical objects such as factories and machines

11. Equilibrium in the Money Market
Occurs when
Quantity of money people are holding
Quantity supplied
Is equal to the quantity of money people want to hold
Quantity demanded
Equilibrium: SS = DD of money
All the money is being willingly held
people are satisfied holding the money that they are actually holding
What people are actually holding (SS) = What people are want to hold.
How is this equilibrium reached?? What are the forces at play?

12. Detour: Bond Prices and Interest Rates
Promise to pay back borrowed funds
At a certain date in the future called ‘redemption date’
The time until the maturity date is called the term to maturity
Some bonds, called perpetuities pay interest for ever but never the principal
Some promise to make payments each month, each year or a certain period of time and then pay back a large sum at the end. Others may promise to make just one payment (eg. 1,3,5,10 yrs) from the date the bond is issued.

13. For example: If a Large corporation or government needs to borrow money, it will issue a new bond and sell it in the bond market place. The amount borrowed is equal to the price of the bond. How?
A bond promises to pay its holder Ghc1000 exactly a year from today.
Suppose you purchase this bond from its issuer for Ghc 800
It means that you are lending the issuer of the bond Ghc 800 and you will be paid back Ghc1000 at the end of the year
You will be getting Ghc 200 more than you lent. So the interest rate will be :200/800=25%

14. Now what if instead of 800 you paid a price of 900 for this same bond?
The bond still promises to pay 1000 one year from now so your annual interest payment now will be 100 which translates to 100/900=11%- which is lower
The interest rate you earn on your bond depends entirely on the price of the bond.
The higher the price, the lower the interest rate
This relationship also holds for all types of bonds not just the simple one-time payment bonds
In General: the more you pay for any bond, the lower your overall rate of return, or interest rate.
There is an inverse relationship between bond price and interest rate

15. Money Market Equilibrium
Figure 5 Money Market Equilibrium
Money ($ billions)
Interest Rate 6% 9% 3% Ms
At a higher interest rate, an excess supply of money causes the interest rate to fall
At the equilibrium interest rate of 6%, the public is content to hold the quantity
of money it is actually holding
At a lower interest rate, an excess demand for money causes the interest rate to rise E Md
600
1,000
1,600

16. Money Market Equilibrium
People holding more money than they would want to hold
Excess supply of money
Money supply > Quantity demanded
Excess demand for bonds (only two options for the individual- holding money or bonds. If people want to hold less money=> they want to hold more bonds.
When there is an excess supply of money in the economy, there is also an excess demand for bonds.
Amount of bonds demanded > amount supplied which will cause the price of bonds to rise and then the interest rate will begin to fall as long as there is excess money supply and excess demand for bonds

17. Money Market Equilibrium
Excess demand of money
People want to hold more money than they are currently holding
Money supply < Quantity demanded
Excess supply of bonds (If people want to hold more money then they want to hold less bonds
Amount of bonds demanded < amount supplied
If demand is less than supply, it pushes prices of bonds downwards which translates into higher interest rates.

18. What Happens When Things Change?
The Central Bank wants to lower the interest rate- it does not just declare changes.
It must change the equilibrium interest rate in the money market by changing the money supply.
Open market purchases
Increase the money supply
Change the equilibrium interest rate

19. An Increase in the Money Supply
Figure 6 An Increase in the Money Supply
At point E, the money market is in equilibrium at an interest rate of 6 percent.
To lower the interest rate, the CB could increase the money supply to $1,600 billion.
Money ($ billions)
Interest Rate 6% 3%
The excess supply of money (and excess demand for bonds) would cause bond prices to rise, and the interest rate to fall until a new equilibrium is established at point F with an interest rate of 3 percent. E F Md
1,000
1,600

20. What Happens When Things Change?
The CB - increase the interest rate
Open market sales
Decrease the money supply
Change the equilibrium interest rate

21. Interest Rate Changes - Affect the Economy
Central Bank increases the money supply, interest rate falls.
How does this affect the economy? A boost in different types of spending:
Spending increases
plant and equipment(lower cost of borrowing)
new housing
consumer durables( cars,furniture etc..)
Central Bank decreases the money supply
Interest rate rises
Spending falls

22. Monetary Policy Control or manipulation of money supply
By the Central Bank
To achieve a macroeconomic goal

23. Monetary Policy Figure 7 Monetary Policy and the Economy Money
($ billions)
Interest
Rate
Real GDP
($ billions)
Real Aggregate
Expenditures
($ trillions)
Ms1
1,000
Ms2
1,600 Md
45°
AEr=3% F
10,000 6% A
AEr=6% 3% B
8,000 E

24. Next Class…
Mr. Kwame Mantey
AD, AS and Macroeconomic Equilbirium