1. Outline: Why agents wish to hold money. The portfolio choice The demand for money Bond prices and interest rates —why they move inversely Bearishness and bullishness in the money market The supply of money Equilibrium in the money market How the money market reaches equilibrium.

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

3. 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.”

4. The Demand for Money (M d ) Where: M d is the total demand for money P is the price level Y is real income (or GDP) r is the rate of interest (or percentage yield of bonds).

5. M d is positively related to P and Y, ceteris paribus. Also, M d is inversely related to r, ceteris paribus.

6. Interest Rate Money ($Billions) 0 MdMd E F 3% 6% 500800 Demand for Money As we move along M d, P and Y 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.

7. Interest Rate Money ($Billions) 0 Md1Md1 E F 3% 6% 500800 Effect of a Change in Price Level (P) or Real GDP (Y) Md2Md2 7001,000 Md1 Md2Md1 Md2 Increase in P, ceteris paribus. Increase in Y, ceteris paribus G H

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

9. 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

10. To say the market is “bullish” is to say that, on average, people forecast that interest rates will decline; hence bond prices are heading up.

11. When people are bearish, they expect interest rates to rise, and bond prices to fall.

12. Bullishness results in a decrease (shift to the left) of the M d function as people buy bonds in anticipation of rising prices. Bullishness means people want to hold less money as a store of value.

13. Interest Rate Money ($Billions) 0 Md1Md1 E F 3% 6% 500800 K Md2Md2 Effects of Market Bearishness

14. The supply of money schedule reveals the stock of money available to satisfy the demand for money at various 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.

15. Interest Rate Money ($Billions) 0 3% 6% 500700 Supply of Money (M s ) J E Ms1Ms1 Ms2Ms2 M s 1  M s 2 Decrease of RRR Decrease of discount rate Open market purchase of government securities

16. Interest Rate Money ($Billions) 0 3% 6% 500800 Equilibrium in the Money market E MsMs MdMd 7% 415 When r = 7%, M s > M d by $85 billion. When r = 3%, M d > M s by $300 billion. When r = 6%, M s = M d

17. 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