The Money Market

Key Concepts People hold (demand) money (think M1) primarily to make transactions The other alternative is to save the money in interest-bearing assets. When money is held as M1, earned interest is forgone, thus the short-term (or nominal) interest rate is the opportunity cost of holding money.

Key Concepts (cont.) As the nominal interest rate rises, the opportunity cost of holding money rises, so the quantity of money held (demanded) falls. Thus the money demand curve is downward sloping with the nominal interest rate plotted on the vertical axis. Money demand will shift to the right if: The aggregate price level rises Real GDP rises Technology is slow to improve If banking institutions become less reliable

Key Concepts (cont.) The liquidity preference model of the interest rate says that the nominal interest rate is determined by the intersection of supply and demand for money in the market for money. The model assumes that the supply of money is vertical and chosen by the Fed and that the demand for money is downward sloping.

The key graph of this model is below:

Things to remember: In the case of the money market, money demand in particular has a short-term horizon The model assumes that there is no inflation, so the nominal interest rate is used on the vertical axis. The desirable quantity of money demand in not infinite Even the wealthiest of persons don’t walk around with all of his/her money in a pocket or checking account There is an opportunity cost of holding money and most people understand that

The Demand for Money When most people are asked why they would like to have money in their pocket, they respond by say “to spend it”. What would cause one to have more money in their pocket today than they had yesterday? To buy more things today Or, things today are more expensive then they were yesterday Indeed, people hold money so that they can buy things What else can you do with your money? You can SAVE it! What would make one interested in saving it? A higher interest rate

The Opportunity Cost of Holding Money Holding money in your pocket is convenient because it allows you to conveniently make purchases The price of that convenience is that money in your pocket earns no interest. Suppose you could put $100 in a 12-month CD that would earn 5% A CD is not very liquid because if you withdraw the money before 12 months, you forfeit most of the interest.

The Opportunity Cost of Holding Money $100 in your pocket or in your checking account (M1) will come at an opportunity cost of 5% or $5. Maybe it is easy to pass up $5 to have the convenience of $100 in your pocket What if the interest rate was 50%? Would you still hold $100 in your pocket when the cost is now $50?

The Opportunity Cost of Holding Money Intuitively, is reflects a general result: The higher the short-term interest rate, the higher the opportunity cost of holding money The lower the short-term interest rate, the lower the opportunity cost of holding money. Why don’t we consider long-term interest rate like 10-year CD’s as the opportunity cost of holding money? Because we hold money to make transactions in the short term. Therefore, we must consider the opportunity cost in the short-term, not the long-run

The Money Demand Curve Since we demand money to make purchases in the short term, the opportunity cost of holding money is the short-term interest rate. We assume that in a short period of time, there will be virtually no inflation, so the nominal interest rate is equal to the real interest rate. Note: It is this assumption that allows us to put the nominal interest rate on the vertical axis of graph of the money market. (you may lost points on the AP exam if you label this axis as the real interest rate) As discussed above, when the interest rate rises, the opportunity cost of holding money rises, so the quantity of money demanded will fall.

An increase in the nominal interest rate will cause a movement upward along the money demand curve

Shifts of the Money Demand Curve Just like there are external factors that shift the demand curve for oranges, there are external factors that shift the demand curve for money NOTE: If an external change makes holding money in your pocket more desirable at any interest rate, the demand curve for money will shift rightward. The most important factors causing the money demand curve to shift are Changes in the aggregate price level Changes in real GDP Changes in banking technology Changes in banking institutions

Changes in the Aggregate Price Level All else equal, higher prices increase the demand for money (a rightward shift of the MD curve). And, lower prices reduce the demand for money (a leftward shift of the MD curve).

Changes in the Aggregate Price Level Think of there being only two places to put your money. You can put money in CDs that provide interest, or you can hold cash that earns no interest.

Changes in the Aggregate Price Level Let’s discuss equilibrium by discussing interest rates above and below i* (interest rate at equilibrium) If i1 > i*, the quantity of money supplied exceeds the quantity of money demanded. Why? Because of high interest rates, CDs are very attractive saving options. In fact, banks find that they can lower the interest rate on CDs and still have plenty of customers ready to buy a CD As interest rates fall, the quantity of money demanded gets closer and closer to M* (quantity of money at equilibrium)

Question What would happen to interest rates and the quantity of money demanded if there was some interest rate i2 that was less than i*? If i2 < i*, the quantity of money demand exceeds the quantity of money supplied. Why? Because of low interest rates CDs are not very attractive saving options. In fact, banks find that they must raise the interest rate on CDs to get more customers ready to buy a CD As interest rates rise, the quantity of money demanded gets closer and closer to M*.

Two Models of the Interest Rate The model of liquidity preference describes equilibrium in the money market This model is a good foundation for learning a similar market in loanable funds that is also useful in describing how interest rates are determined and the impact of money policy and other more advanced topics.