Lesson 10-2 Demand, Supply, and Equilibrium in the Money Market

The Demand for Money   The demand for money is the relationship between the quantity of money people want to hold and the factors that determine that quantity. Motives for Holding Money The transactions demand for money is money people hold to pay for goods and services they anticipate buying. The precautionary demand for money is the money people hold for contingencies. The speculative demand for money, according to John Maynard Keynes, is the money held in response to concern that bond prices and the prices of other financial assets might change.

Money demand Demand for real money balances: L (r ) r M/P interest rate Demand for real money balances: L (r ) As we learned in chapter 4, the nominal interest rate is the opportunity cost of holding money (instead of bonds), so money demand depends negatively on the nominal interest rate. Here, we are assuming the price level is fixed, so π = 0 and r = i. M/P real money balances CHAPTER 10 Aggregate Demand I

Interest Rates and the Demand for Money   The quantity of money people hold for all the motives is likely to vary with the interest rates they can earn from alternative assets such as bonds. When interest rates rise, the quantity of money held falls. When interest rates fall, the quantity of money held rises. People can satisfy their transactions and precautionary demands for money with various combinations of money and bond funds (or liquid investments).

Implications of the bond fund approach are as follows:   A household is more likely to adopt a bond fund strategy when the interest rate is higher. People are more likely to use a bond fund strategy when the cost of transferring funds is lower. Speculative demand for money depends upon the expected future price of bonds. The lower the interest rates, the higher bond prices and the greater the likelihood that investors will expect bond prices to fall.

The Demand Curve for Money   The demand curve for money shows the quantity of money demanded at each interest rate, all other things unchanged. A rise in the interest rate lowers the quantity of money demanded. A fall in the interest rate raises the quantity of money demanded.

Other Determinants of the Demand for Money   Real GDP The price level Expectations T Transfer costs Preferences Household attitudes toward risk affect money demand. Household attitudes toward the importance of cash balances on hand affect money demand.

The Supply of Money   The supply curve of money shows the relationship between the quantity of money supplied and the market interest rate, all other determinants of supply unchanged. The Fed is able to control the total quantity of reserves in the banking system through open-market operations. We assume that the money supply is a fixed multiple of reserves. The supply curve of money as a function of the interest rate is therefore a vertical line.

Money supply The supply of real money balances is fixed: r M/P interest rate The supply of real money balances is fixed: We are assuming a fixed supply of real money balances because P is fixed by assumption (short-run), and M is an exogenous policy variable. M/P real money balances CHAPTER 10 Aggregate Demand I

Equilibrium in the Market for Money   The money market is the interaction among institutions through which money is sup-plied to individuals, firms, and other institutions that demand money. Money market equilibrium occurs at the interest rate at which the quantity of money demanded is equal to the quantity of money supplied. Money market equilibrium can be illustrated graphically.

Equilibrium r interest rate The interest rate adjusts to equate the supply and demand for money: r1 L (r ) M/P real money balances CHAPTER 10 Aggregate Demand I

Changes in Money Demand   A decrease in money demand, all other things unchanged, shifts the money demand curve to the left and results in a new money market equilibrium with a lower interest rate. A decrease in money demand means that people want more bonds and less money thereby driving up the price of bonds and lowering the interest rate. An increase in money demand means that people want to hold more money and fewer bonds thereby driving down the price of bonds and raising the interest rate. An increase in money demand causes the money demand curve to shift to the right resulting in a new equilibrium with a higher interest rate.

Changes in the Money Supply   An increase in the money supply shifts the money supply curve to the right resulting in a new equilibrium with a lower interest rate. An increase in the money supply gives people more money than they want and causes them to buy bonds which drives the price of bonds up and the interest rate down. A decrease in the money supply shifts the money supply curve to the left resulting in a new equilibrium with a higher interest rate. A decrease in the money supply gives people less money than they want and causes them to sell bonds which drives the price of bonds down and the interest rate up. The Fed sells bonds to reduce the money supply and buys bonds to increase the money supply.

Money Market Equilibrium

Rise in Income 1. Income ≠, Md ≠, Md shifts out to right 2. Ms unchanged 3 i* rises from i1 to i2

Rise in Price Level 1. Price level ≠, Md ≠, Md shifts to right 2. Ms unchanged 3. i* rises from i1 to i2

Rise in Money Supply 1. Ms ≠, Ms shifts out to right 2. Md unchanged 3. i* falls from i1 to i2

The Money Market Nominal Interest Rate (i) MS 7% 5% 3% MD 400 700 1000 Quantity of Money ($ billions) Money Surplus Money Shortage

 FIGURE 25.5 The Supply of Money How the Federal Reserve Controls the Money Supply The Supply Curve for Money  FIGURE 25.5 The Supply of Money If the Fed’s money supply behavior is not influenced by the interest rate, the money supply curve is a vertical line. Through open market operations, the Fed can have the money supply be whatever value it wants.