Module 28: Money Market Objectives: Money demand curve Why

Module 28: Money Market
1. Objectives:
a. Money demand curve
b. Why the liquidity preference model determines interest rates
2. Opportunity cost of holding money
a. Money in pocket earns no interest
b. $100 in 12-month CD at 5% interest = $5 yield after 12 months
c. Convenience of $100 in pocket versus $5 profit
i. Which would you choose?
ii. What about at 50% interest?
iii. What about 0.5% interest?
d. Higher short term interest rate, higher the opportunity cost of holding money
i. Emphasis is on short term. People don’t hold cash for long term, but for making
convenient purchases in the immediate future.
3. Money demand curve
a. ***Students draw their own curves and show how external factors impact the curve.
b. Assume: short period of time = no inflation, so nominal interest = real interest
c. When interest rates rise, opportunity cost of holding money rises, so demand will fall
d. Money demand curve downward sloping (pic page 246 in binder)
e. Increase in interest rate causes upward movement of curve
4. Shifts in the curve
a. Changes in aggregate price level
i. High prices increase demand for money (shift right)
ii. Low shift left
iii. Demand for money is proportional to price level. Price level rises 20%, quantity
of money demanded rises 20%
1. If prices raised 20%, it requires 20% more money to buy things
b. Changes in real GDP
i. Larger quantity of goods and services bought  larger quantity of money we
will want to hold
ii. Increase in real GDP shifts curve right
c. Changes in technology
i. Tech tends to reduce money demand  easier for public to make purchases
without holding money
ii. Shifts curve left
d. Changes in institutions
i. Regulations that make it more attractive to keep money in banks shifts curve
ii. Concern for political and financial chaos causes curve to shift right (cash
5. Money and interest rates
a. Liquidity preference model of interest rates
i. Interest rate determined by supply and demand for money in the money market
ii. Equilibrium interest rate
1. MS = money supply; determined by Fed, fixed.
a. Independent of interest rate; depicted as vertical line on money
demand curve.
2. I* = equilibrium interest rate is horizontal line, passes through
intersection of MS and MD
a. Interest rate where money supply and money demand meet
3. If I > I*, quantity of money supplied exceeds demand
a. Because CDs are very attractive
b. As rates fall, quantity of money demanded gets closer to M*
4. If I<1*, there is excess demand, insufficient supply
a. CDs not attractive, banks must raise rates
b. As rates rise, quantity of money demand approaches M*
b. Other models
i. The market for loanable funds is the other principal model for how interest
rates are governed.