The Money Market and
the Loanable Funds
Market
1
The Demand for Money
People are face with the decision to hold their wealth as money OR as
interest bearing assets.
Opportunity Cost of holding money?
Forgone interest!
3 types of money demand (motives for holding money):
1. Transactions: To make purchases of goods and services
2. Precautionary: To serve as protection against an unexpected need
3. Speculative: To serve as a store of wealth (money for investment
purposes)
The Demand for money shows an inverse relationship between
interest rates and the quantity of money demanded
1. What happens to the quantity demanded of money when interest rates increase?
Quantity demanded falls because individuals would prefer to have interest earning
assets instead
2. What happens to the quantity demanded when interest rates decrease?
Quantity demanded increases. There is no incentive to convert cash into interest
earning assets
2
The Demand for Money
Inverse relationship between interest rates and
the quantity of money demanded
Nominal
Interest Rate
20%
5%
2%
DMoney
0
Quantity of Money (billions of dollars)
3
The Demand for Money
What happens if price level increase?
Money Demand Shifters
1.
Changes
in
price
level
Nominal
& real GDP
Interest Rate
2. Changes in income
20%
3. Changes in taxation
that affects investment
5%
2%
0
DMoney1
DMoney
Quantity of Money (billions of dollars)
4
The Supply for Money
The U.S. Money Supply is set by the Federal
Reserve System (FED)
Interest
Rate (ir)
20%
The FED is a nonpartisan
government office that sets and
adjusts the money supply to
adjust the economy
5%
This is called Monetary
Policy.
2%
SMoney
DMoney
200 Quantity of Money (billions of dollars)
5
Increasing the Money Supply
Interest
Rate (ir)
SM SM1
10%
5%
If the FED increases the
money supply, a temporary
surplus of money will
occur at 5% interest.
The surplus will cause the
interest rate to fall to 2%
2%
DM
200
Increase
money supply
250
How does this
affect AD?
Quantity of Money
(billions of dollars)
Decreases
interest rate6
Increases
investment
Increases
AD
Decreasing the Money Supply
Interest
Rate (ir)
SM1 SM
10%
5%
2%
If the FED decreases the
money supply, a temporary
shortage of money will occur
at 5% interest.
The shortage will cause the
interest rate to rise to 10%
How does this
affect
AD?
D
M
150
Decrease
money supply
200
Quantity of Money
(billions of dollars)
Increase
interest rate
Decrease Decrease AD
investment
7
Loanable Funds Market
Q: Is an interest rate of 50% good or bad?
A: Bad for borrowers but good for lenders
The loanable funds market brings together those who demand
funds to borrow (Dlf) with those who want to lend by
supplying funds (Slf)
4 Groups Demand and Supply Loanable Funds:
1. Consumers
2. Government
3. Foreigners
4. Businesses
Demand- Inverse relationship between real interest rate and
quantity loans demanded (negative slope)- more loans
demanded at lower interest rates.
Supply- Direct relationship between real
interest rate and quantity loans supplied (positive slope)
9
Loanable Funds Market
At the equilibrium real interest rate the amount
borrowers want to borrow equals the amount lenders
want to lend.
Real Interest
Rate
SLenders
re
DBorrowers
QLoans
Quantity of Loans
10
Loanable Funds Market
Demand Shifters
1. Confident businesses
2. Changes in
government
borrowing/spending
3. Consumer concerns
about future
4. Rising incomes
Supply Shifters
1. Government reduces
interest tax rate on
interest income
2. Other actions by the
FED…
11