The Money Market and the Interest Rate

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• The Money Market and the Interest Rate

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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.

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An Individuals 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 individuals 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

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An Individuals 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

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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 dont
  change
• A drop in interest ratewhich lowers the
  opportunity cost of holding moneywill increase
  quantity of money demanded

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Figure 1 The Money Demand Curve
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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

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Figure 2 A Shift in the Money Supply Curve
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Figure 3 Shifts and Movements Along the Money
Demand CurveA Summary
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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.

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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

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Figure 4 The Supply of Money
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Figure 5 Money Market Equilibrium
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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

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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
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Figure 6 An Increase in the Money Supply
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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

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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

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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

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Figure 7(a) Monetary Policy andthe Economy
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Figure 7(b) Monetary Policy andthe Economy
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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

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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 ?G
• Real GDP and real income are higher
• But rise is less than 1/(1 MPC) x ?G
• 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

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An Increase in Government Purchases
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Figure 8(a) Fiscal Policy and theMoney Market
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Figure 8(b) Fiscal Policy and theMoney Market
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Crowding Out Effect

• When effects in money market are included in
  short-run 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

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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

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Expectations and the Money Market

• Important insight of money market analysis in
  this chapter
• There is an inverse relationship between a bonds
  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

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Figure 9 Interest Rate Expectations