Principles of Macroeconomics

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Principles of Macroeconomics

• Economics 202
• Ryan Herzog

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Interest Rates

• Interest is the fee borrowers pay to lenders for
  the use of their funds
• Banks also pay interest to borrow funds from
  savers
• Interest rate is the annual interest payment on a
  loan expressed as a percentage of the loan

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The Money Market
Interest rates are the price of money Firms and
households demand money When interest rates are
above equilibrium, the price to borrow money is
high. Banks lower interest rates. When interest
rates are below equilibrium, the price to borrow
money is low. Banks raise interest rates.
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Money Demand

• Why is money demand downward sloping?
• Remember individuals do not want to hold money.
• Money does not earn interest
• Individuals would rather use excess cash to
  purchase interest bearing assets
• bonds, CDs, and treasury bills

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Money Demand

• Two reasons to hold money
• Transaction motive
• Individuals hold money to buy things
• Speculative motive

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Transaction Motive

• Assumptions
• There are only two kinds of assets bonds and
  money.
• The typical households income arrives once a
  month, at the beginning of the month.
• Household spend a constant amount everyday
• Spending is exactly equal to income for the
  month.

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Transaction Motive
Nonsynchronization of income and spending
Households receive income at the beginning of
every period but spend evenly throughout the
month. There is a mismatch between when income
arrives and goes out.
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Bank Account Prior Bond Purchase
Monthly income 1200 Spending is constant,
spend 40 everyday. At the end of the month your
account has zero dollars Your average monthly
holdings are 600 You do not own any interest
bearing assets
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Bank Account After Bond Purchase
Monthly Income 1200 Now at the beginning of
every month you purchase an interest bearing
assets worth 600 Spend 40 per day, but at the
end of the 15th day your account is at zero. On
the 15th day you sell the asset plus any interest
earned. Average holdings are 300 per month
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Optimal Balances

• The level of average money holdings that earns
  the most profit, taking into account both the
  interest earned on bonds and the costs paid for
  switching from bonds to money.
• When interest rates are high, people want to take
  advantage of the high returns on bonds so they
  choose to hold very little money

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Example (not on the test)
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Speculative Motive

• Market value of bonds is inversely related to the
  interest rate
• When the interest rates are high the market value
  (price) of bonds are low
• Suppose you are considering the purchase of a
  bond that pays 1000 in one year
• As the price increases (950) the interest rate
  decreases
• (1000-950)/950 5.3
• As the price decreases (900) the interest rate
  increases
• (1000-900)/900 11.1

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Speculative Motive

• Investors speculate that future interest rates
  will be lower thus increasing the market value of
  bonds
• They will buy bonds when the market values
  (prices) are low (interest rates high) and hold
  little cash
• Expected interest rates should decline,
  increasing the value of bonds
• They will sell bonds when the market values
  (prices) are high (interest rates low) and hold
  more cash
• Expected interest rates should increase,
  decreasing the value of the bonds

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Demand for Money

• Opportunity Cost
• Holding money means you forgo the interest that
  could be earned.
• A higher interest rate increases the cost of
  holding money

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Money Market
The Fed controls the money supply Money demand is
determined by the interest rate, price levels,
and income (transaction volume)
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Determinants of Money Demand

• Price Level (P)
• When individuals face higher prices they will
  demand more money at all interest rates
• Income (Y)
• When income increases the number of transactions
  increase which increases the demand of money at
  all interest rates.
• Interest Rates
• Effect the quantity of money demand, movements
  along the money demand curve

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Example Money Demand
An increase in prices (p) or income/output (Y)
will increase the demand of money. 1. The money
demand curve shifts to the right 2. This causes
an excess demand for money 3. The excess demand
of money will cause the interest rates to increase
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Example Money Supply
When the Fed elects to increase the money supply
(lower reserve rate, lower discount rate, or buy
bonds) 1. The money supply curve shifts the
right. 2. This creates an excess supply of
money 3. Banks must lower interest rates to
remove the excess money