Expected returns/interest rate on illiquid assets. ...

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Chapter 14

• Money, Interest Rates, and Exchange Rates
• November 2009

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Preview

• What is money?
• The supply of money
• The demand for money
• Equilibrium in the money market

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What Is Money?

• Money is any asset that is widely used and
  accepted as a means of payment.
• So, a countrys quantity of money (Ms) includes
• All currency with the public and
• The value of all checking accounts
• bank deposits in a foreign currency are excluded
  from this definition.
• M1 and M2 are two well-known periodically
  published measures of the quantity of money

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What Is Money? (cont.)

• Money is very liquid it can be easily and
  quickly used to pay for goods and services.
• Money, however, pays little or no rate of
  return.
• Suppose we group assets into money (liquid
  assets) and all other assets (illiquid assets).
  These other assets are less liquid but pay a
  higher return.

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Money Supply

• The quantity of money is also called the money
  supply
• Who controls the money supply?
• Central banks determine the money supply.
• In the US, the central bank is the Federal
  Reserve System.
• The Federal Reserve directly regulates the amount
  of currency in circulation.
• It indirectly controls the amount of checking
  deposits issued by private banks.

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Money Demand

• Money demand is the amount of assets that people
  are willing to hold as money (instead of illiquid
  assets).
• What influences our willingness to hold money?

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What Influences Individual Demand for Money?

• Expected returns/interest rate on illiquid
  assets.
• Risk the risk of holding money principally comes
  from unexpected inflation, thereby unexpectedly
  reducing the purchasing power of money.
• but many other assets have this risk too, so this
  risk is not very important in money demand
• Liquidity A need for greater liquidity occurs
  when either the price of transactions increases
  or the quantity of goods bought in transactions
  increases.

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What Influences Aggregate Demand for Money?

• Interest rates money pays little or no interest.
  So, the interest rate on non-money assets (such
  as bonds) is the opportunity cost of holding
  money (instead of non-money assets).
• A higher interest rate means a higher opportunity
  cost of holding money ? lower money demand.
• Prices the prices of goods and services bought
  in transactions will influence the willingness to
  hold money to conduct those transactions.
• A higher price level means a greater need for
  liquidity to buy the same amount of goods and
  services ? higher money demand.

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What Influences Aggregate Demand for Money?
(cont.)

• Income greater income implies more goods and
  services can be bought, so that more money is
  needed to conduct transactions.
• A higher real national income (GNP) means more
  goods and services are being produced and bought
  in transactions, increasing the need for
  liquidity ? higher money demand.

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A Model of Aggregate Money Demand

• The aggregate demand for money can be expressed
  by
• Md P x L(R,Y)
• where
• P is the price level
• Y is real national income
• R is the interest rate
• L(R,Y) is the aggregate real money demand (Md/P)

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Functional Notation

• L is the real aggregate demand for money (Md/P)
• L(R,Y) is a concise mathematical way of saying L
  depends on R and Y.
• Some people say, L is a function of R and Y.
  This is why L(R,Y) is said to be an instance of
  functional notation.
• If Y is constant, L and R are inversely related
  when one increases the other decreases
• If R is constant, L and Y are directly related
  when one increases so does the other

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A Model of Aggregate Money Demand

• From Md P x L(R,Y)
• we get Md/P L(R,Y)
• This is the aggregate real money demand. It is
  directly related to GNP and inversely related to
  the interest rate.

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Aggregate Real Money Demand (cont.)
For a given level of income, real money demand
decreases as the interest rate increases.
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Aggregate Real Money Demand (cont.)

When income increases, real money demand
increases at every interest rate.
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The Money Market

• Equilibrium in the money market requires
• Ms Md (14-3)
• Alternatively, equilibrium requires the supply of
  real money be equal to the demand for real money
  (by dividing both sides by the price level)
• Ms/P L(R,Y) (14-4)

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Money Market Equilibrium
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Two markets foreign exchange and money

• So far, we have seen the equilibrium conditions
  for the two asset markets
• The foreign exchange market, and
• The money market

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Whats next?

• Next, we will look at the equilibrium equation
  for the goods market
• Read chapter 16, up to the section How Output is
  Determined in the Short Run