Demand for Money & the Money Market

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Demand for Money and the
Money Market
The Opportunity Cost of Holding Money
 People weigh decisions about how much money to have on hand
 Opportunity cost is interest that would be earned if money were invested,
so opportunity cost changes when interest rates do
Interest Rates & Opportunity Cost
June 2007
June 2008
Federal funds rate
5.25%
2.00%
One-month certificate of deposit (CD)
5.3%
2.5%
0
0
Currency
 Higher the interest rate, the higher the opportunity cost of holding money
 Lower the interest rate, the lower the opportunity cost of holding money
*Short-term interest rates affect Money Demand
The Money Demand Curve
 Because interest rate affects the cost of holding money,
quantity of money that people want to hold is negatively
related to the interest rate
Note that vertical axis reflects nominal
interest rate, as this includes both foregone
real return & expected loss due to inflation
Interest rates are used for comparison
because interest is the gain on near-money
assets
Factors that Shift Money Demand
Changes in Aggregate Price Level –
Higher prices means that we need
to hold onto more cash. Price
increase and increase in money
demand is proportional.
2. Changes in Income—
As people accumulate more wealth,
they will hold onto more money.
1.
Factors that Shift Money Demand
3. Changes in Banking Technology–
Increased access to deposits means
less demand to hold cash on hand.

Changes in Institutions– Changes
in banking laws can
increase/decrease demand for
money.
Money & Interest Rates
 Fed funds rate – Rate at which banks lend reserves to each
other to meet the required reserve ratio, impacts interest rates
 Liquidity preference model of the interest rate shows how
quantity of money supplied by the Fed varies with the interest
rate
Monetary Equation of Exchange
 Like the Savings-Investment Spending Identity, this
is always true
 Depicts the relationship between money supply,
income velocity, price level, and real output
MV = PQ
 Changes in money supply result in changes in
nominal GDP (P  Q)