The Money Market and the Interest Rate
1
The Demand For Money
• Demand for money does not mean how much
money people would like to have. Rather, it
means how much money people would like to
hold, given constraints they face.
2
An Individual’s Demand for
Money
• At any given moment, total amount of wealth we
have is given
– Total wealth = Money + Other assets
– If we want to hold more wealth in form of money, we
must hold less wealth in other assets
– So, an individual’s quantity of money demanded is the
amount of wealth individual chooses to hold as money
• Why do people want to hold some of their wealth
in form of money?
– Money is a means of payments
– Other forms of wealth provide a financial return to their
owners
– Money pays either very little interest or none at all
• When you hold money, you bear an opportunity cost
– Interest you could have earned
3
An Individual’s Demand for
Money
• Individuals choose how to divide wealth
between two assets
– Money, which can be used as a means of payment
but earns no interest
– Bonds, which earn interest, but cannot be used as
a means of payment
• What determines how much money an
individual will decide to hold?
• Price level
• Real income
• Interest rate
4
The Money Demand Curve
• Figure 1 - a money demand curve
– Tells us total quantity of money demanded in
economy at each interest rate
– Curve is downward sloping
– As long as other influences on money
demand don’t change
• A drop in interest rate—which lowers the
opportunity cost of holding money—will
increase quantity of money demanded
5
Figure 1: The Money
Demand Curve
6
Shifts in the Money Demand Curve
• What happens when something other than
interest rate changes quantity of money
demanded?
– Curve shifts
• A change in interest rate moves us along money
demand curve
7
Figure 2: A Shift in the
Money Supply Curve
8
Figure 3: Shifts and Movements Along the
Money Demand Curve—A Summary
9
The Supply of Money
• Money supply is determined by the Fed. And we
assume that the quantity of money supplied is not
related to interest rate.
• So, interest rate can rise or fall, but money
supply will remain constant unless and until Fed
decides to change it
• So, the relationship between interest rate and the
quantity of money supplied can be described by a
vertical line.
1
Change in Money Supply
• Open market purchases of bonds
– inject reserves into banking system
– Shift money supply curve rightward by a multiple of
reserve injection
• Open market sales have the opposite effect
– Withdraw reserves from system
– Shift money supply curve leftward by a multiple of
reserve withdrawal
11
Figure 4: The Supply of
Money
Interest
Rate
6%
3%
Ms1
Ms2
E
J
500
700
Money
($ Billions)
1
Figure 5: Money Market
Equilibrium
1
How money market reaches an
equilibrium?
• At a higher interest rate, supply of money
is larger than demand of money
• At a lower interest rate, demand of money
is larger than supply of money
1
How the Fed Changes the
Interest Rate
• Fed officials cannot just declare that interest rate should
be lower
• Fed must change the equilibrium interest rate in the money
market
• Does this by changing money supply
– The process works like this
Fed can raise interest rate as well, through open market sales
of bonds
1
Figure 6: An Increase in the
Money Supply
1
How the Interest Rate Affects
Spending
• Lower interest rate stimulates business
spending on plant and equipment
• Interest rate changes also affect spending
on new houses and apartments that are
built by developers or individuals
– Mortgage interest rates tend to rise and fall
with other interest rates
1
How the Interest Rate Affects
Spending
• Interest rate affects consumption spending on
big ticket items
– Such as new cars, furniture, and dishwashers
– Economists call these consumer durables because they
usually last several years
• Can summarize impact of money supply
changes as follows
– When Fed increases money supply, interest rate falls,
and spending on three categories of goods increases
• Plant and equipment
• New housing
• Consumer durables (especially automobiles)
– When Fed decreases money supply, interest rate rises,
and these categories of spending fall
1
Monetary Policy and the
Economy
– What happens when Fed conducts open market purchases of
bonds
– What happens when Fed conducts open market sales of
bonds
1
Figure 7(a): Monetary Policy and
the Economy
2
Figure 7(b): Monetary Policy and
the Economy
2
An Increase in Government
Purchases
• What happens when government changes its fiscal
policy
– Say, by increasing government purchases
• Increase in government purchases will set off
multiplier process
– Shifting the aggregate expenditure upward
– Increasing GDP and income in each round
• But ,also sets in motion forces that shift AE
downward
– As GDP rises, demand of money increases
– As demand of money increases, interest rate rises
– As interest rate becomes higher, consumption and
investment spending decrease so that AE gets smaller
2
An Increase in Government
Purchases
• Interest rate is an automatic stabilizer
• In short-run, increase in government purchases causes
real GDP to rise
– But not by as much as if interest rate had not increased
– Aggregate expenditure line is higher, but by less than ΔG
– Real GDP and real income are higher
• But rise is less than [1/(1 – MPC)] x ΔG
– Money demand curve has shifted rightward
• Because real income is higher
– Interest rate is higher
• Because money demand has increased
– Autonomous consumption and investment spending are
lower
• Because the interest rate is higher
2
An Increase in Government
Purchases
2
Figure 8(a): Fiscal Policy and the
Money Market
2
Figure 8(b): Fiscal Policy and the
Money Market
2
Crowding Out Effect
• When effects in money market are included in shortrun macro model
– An increase in government purchases raises interest rate
and crowds out some private investment spending
– May also crowd out consumption spending
• In the classical model, an increase in government
purchases causes complete crowding out so that the
fiscal policy has no effect on potential GDP
• In short-run, however, conclusion is somewhat
different
– Crowding out is not complete
– Investment spending falls, and consumption spending
may fall, but together, they do not drop by as much as
rise in government purchases
– In short-run, real GDP rises
2
Other Spending Changes
• Increases in G, IP, NX, and a, as well as
decreases in taxes, all shift AE line upward
– Real GDP rises, but so does interest rate
– Rise in equilibrium GDP is smaller than if interest
rate remained constant
• Decreases in G, IP, NX, and a, as well as
increases in taxes, all shift AE line
downward
– Real GDP falls, but so does interest rate
– Decline in equilibrium GDP is smaller than if interest
rate remained constant
2
Expectations and the Money
Market
• Important insight of money market analysis in this
chapter
– There is an inverse relationship between a bond’s price
and interest rate it earns for its holder
– Therefore, if people expect interest rate to fall, they must
be expecting price of bonds to rise
• A general expectation that interest rates will rise
(bond prices will fall) in the future will cause money
demand curve to shift rightward in the present
• When public as a whole expects interest rate to
rise (fall) in the future, they will drive up (down)
interest rate in the present
2
Figure 9: Interest Rate
Expectations
3