1. Demand, Supply, and Equilibrium in the Money Market

2. Introduction
Factors that affect a country’s money supply or demand are among the most powerful determinants of its currency’s exchange rate against foreign currencies.
This chapter combines the foreign-exchange market with the money market to determine the exchange rate in the short run.
It analyzes the long-term effects of monetary changes on output prices and expected future exchange rates.
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3. Money Defined: A Brief Review
What Is Money?
Assets widely used and accepted as a means of payment.
Money is very liquid, but pays little or no return.
All other assets are less liquid but pay higher return.
Money Supply (Ms)
Ms = Currency + Checkable Deposits
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4. 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.

5. 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.

6. 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 Aggregate Demand I

7. 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).

8. 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.

9. 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.

10. Money Defined: A Brief Review
How the Money Supply Is Determined
An economy’s money supply is controlled by its central bank.
The central bank:
Directly regulates the amount of currency in existence
Indirectly controls the amount of checking deposits issued by private banks
Copyright © 2003 Pearson Education, Inc.

11. 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.

12. 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 Aggregate Demand I

13. 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.

14. 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 Aggregate Demand I

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

16. Money Market Equilibrium

17. 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.

18. 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.

19. Changes in Equilibrium Interest Rates
One of the most useful features of the liquidity preference framework is that it allows us to see how changes in the demand and supply of money affect interest rates.
Equilibrium interest rates will increase if there is a…
Increase in money demand (+)
Decrease in money supply (+)
Equilibrium interest rates will decrease if there is a…
Decrease in money demand (-)
Increase in money supply (-)

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

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

22. Shifts in Money Demand
In Keynes original analysis, two things would cause the demand for money to change:
An Increase in Income/Wealth
With more income, people would like to consume more. To increase consumption, you need more money.
Money demand shifts right, causing interest rates to rise
An Increase in Prices
With higher prices, the same quantity of money held buys fewer goods and services. To maintain consumption, people need to hold more money.
We can also consider several other factors that increase money demand:
An increase in the risk of non-monetary assets (i.e. bonds)
A decrease in the liquidity of non-monetary assets
An increase in the nominal interest rate on money

23. Interest Rates Rise when Income Rises
Nominal Interest Rate (i) MS 7% 5%
MD2
MD1
700
900
Quantity of Money ($ billions)

24. Interest Rates Fall when Bonds become less Risky
Nominal Interest Rate (i) MS 5% 3%
MD1
MD2
400
700
Quantity of Money ($ billions)

25. Shifts in Money Supply
Since the central bank is the sole issuer of money, any changes in the money supply must come directly from central bank policy (monetary policy)
At its most basic level, an increase in the money supply is just the central bank printing up more money
Operationally, the central bank changes the money supply through three channels (much more on this later)
Buying and selling bonds from the public in exchange for money
Changing banks reserve requirement
Changing the discount rate at which banks borrow from the central bank at.
Using these tools, the central bank can lower interest rates by raising the money supply and increase rates by cutting the money supply.
Note that this analysis only considers the short run and not the long term consequences of changes to the money supply.

26. Interest Rates and an Increase in the Money Supply Growth Rate
So what happens to interest rates if the central bank increases the rate at which the money supply grows?
The liquidity preference theory argues a decrease in interest rates as people will hold excess cash balances
People will try to convert their excess cash into bonds.
Doing so will increase the number of people offering loans, which must push interest rates down.
Friedman’s theory argues an increase in interest rates as the expansion in the money supply growth rate will cause income, price levels, and expected inflation to all rise.

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