1. Topic 7
The Money Market
and
the Interest Rate

2. 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.

3. An Individual’s 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 individual’s 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

4. An Individual’s 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

5. 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 don’t change
A drop in interest rate—which lowers the opportunity cost of holding money—will increase quantity of money demanded

6. Figure 1: The Money Demand Curve

7. 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

8. Figure 2: A Shift in the Money Supply Curve

9. Figure 3: Shifts and Movements Along the Money Demand Curve—A Summary

10. 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.

11. 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

12. Figure 4: The Supply of Money
700 M 2 s
Money
($ Billions)
Interest
Rate 6% E J
500 3% 1

13. Figure 5: Money Market Equilibrium

14. 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

15. 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

16. Figure 6: An Increase in the Money Supply

17. 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

18. 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

19. 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

20. Figure 7(a): Monetary Policy and the Economy

21. Figure 7(b): Monetary Policy and the Economy

22. 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

23. 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 ΔG
Real GDP and real income are higher
But rise is less than [1/(1 – MPC)] x ΔG
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

24. An Increase in Government Purchases

25. Figure 8(a): Fiscal Policy and the Money Market

26. Figure 8(b): Fiscal Policy and the Money Market

27. 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

28. 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

29. Expectations and the Money Market
Important insight of money market analysis in this chapter
There is an inverse relationship between a bond’s 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

30. Figure 9: Interest Rate Expectations