THE MONEY MARKET

MODULE 28

THE OPPORTUNITY COST OF HOLDING MONEY

Individuals and firms hold some of their assets in the form of money for the convenience that money provides in paying for purchases directly.

However, the opportunity cost is that this money held does not earn any interest.

THE OPPORTUNITY COST OF HOLDING MONEY

The opportunity cost of holding money changes when the overall level of interest rates changes.

When the interest rates fall, the opportunity cost of holding money falls, too.

THE SHORT-TERM INTEREST RATES

The short-term interest rates are rates on financial assets that mature within less than a year.

These short-term interest rates tend to move together because no asset will consistently offer a higher-than-average or lower-than-average interest rate.

THE SHORT-TERM INTEREST RATES

When the short-term interest rates fall, the interest rate on money (0%) remains the same. That is why the opportunity cost of money falls when short-term interest rates fall.

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.

THE LONG-TERM INTEREST RATES

Long-term interest rates (rates on bonds or loans that mature in several years) don’t necessarily move with short-term interest rates.

In practice, long-term interest rates reflect the average expectation in the market about what’s going to happen to short-term interest rates in the future.

THE MONEY DEMAND CURVE

Because the overall level of interest rates affects the opportunity cost of holding money, the quantity of money individuals and firms want to hold is inversely related to the interest rate.

The money demand curve shows the relationship between the interest rate and the quantity of money demanded by the public.

THE MONEY DEMAND CURVE

The money demand curve slopes downward because a higher interest rate increases the opportunity cost of holding money, leading the public to demand less quantity of money.

THE MONEY DEMAND CURVE

THE MONEY DEMAND CURVE

We use nominal interest rate (r) because the opportunity cost of holding money includes both the forgone real return and the expected loss due to inflation.

The horizontal axis shows the quantity of money demanded.

SHIFTS OF THE MONEY DEMAND CURVE

The money demand curve can be shifted by a number of factors.

An increase in the demand for money corresponds to a rightward shift of the MD curve, raising the quantity of money demanded at any given interest rate.

A decrease in the demand for money corresponds to a leftward shift of the MD curve, reducing the quantity of money demanded at any given interest rate.

SHIFTS OF THE MONEY DEMAND CURVE

The most important factors that cause the money demand curve to shift are:

1. Changes in the aggregate price level

2. Changes in real GDP

3. Changes in banking technology

4. Changes in banking institutions

CHANGES IN AGGREGATE PRICE LEVEL

Higher prices increase the demand for money (a rightward shift of the MD curve) and lower prices decrease the demand for money (a leftward shift of the MD curve).

The demand is proportional to the price level, because when the prices of everything change by a certain percentage, it will take the same percentage more or less of money to purchase the same basket of goods and services.

CHANGES IN REAL GDP

Households and firms hold money to facilitate purchases of goods and services.

The larger the quantity of goods and services they buy, the more money they want to hold at any given interest rate.

An increase in real GDP shifts the MD curve rightward; a fall in real GDP shifts the MD curve leftward.

CHANGES IN TECHNOLOGY

Advances in information technology have tended to reduce the demand for money because it is easier for the public to make purchases without holding significant sums of money.

An example is the ATM card.

CHANGES IN INSTITUTIONS

When banking regulations changed and allowed banks to pay interest on checking account funds, the demand for money rose and shifted the money demand curve to the right.

THE EQUILIBRIUM INTEREST RATE

The liquidity preference model of the interest rate says that the interest is determined by the supply and demand for money in the market for money.

The money demand curve, MD, is combined with the money supply curve, MS.

This model shows how the quantity of money supplied by the FED varies with the interest rate.

THE EQUILIBRIUM INTEREST RATE

The Federal Reserve can increase or decrease the money supply through open-market operations, by selling or buying Treasury bills.

It can also lend via the discount window or change the reserve requirement.

In this way, the Fed chooses the level of the money supply that it believes will achieve its interest rate target.

THE EQUILIBRIUM INTEREST RATE

The money supply curve is a vertical line, with a horizontal intercept at the level of money supply chosen by the Fed.

The money market equilibrium is at the point where MD and MS cross. At this point the quantity of money demanded equals the money supply, leading to the equilibrium interest rate r.

THE EQUILIBRIUM INTEREST RATE

THE EQUILIBRIUM INTEREST RATE

The money supply curve is a vertical line, with a horizontal intercept at the level of money supply chosen by the Fed.

The money market equilibrium is at the point where MD and MS cross. At this point the quantity of money demanded equals the money supply, leading to the equilibrium interest rate r.

THE MONEY MARKET: Interaction of Money Supply and Demand

A. The money market combines demand with supply of money.

B. Equilibrium changes with a shift in the supply of money.

C. If the quantity demanded exceeds the quantity supplied, people sell assets like bonds to get money. This causes bond supply to rise, bond prices to fall, and a higher market rate of interest.

THE MONEY MARKET: Interaction of Money Supply and Demand

D. If the quantity supplied exceeds the quantity demanded, people reduce money holdings by buying other assets like bonds. Bond prices rise, and lower market rates of interest result.

E. Monetary authorities can shift supply to affect interest rates, which in turn affect investment and consumption and aggregate demand and, ultimately, output, employment, and prices.