Transcript Supply of Money

Outline:
•Why agents wish to hold money.
•The portfolio choice
•The demand for money
•Bond prices and interest rates
—why they move inversely
•Bearishness and bullishness in the money
market
•The supply of money
•Equilibrium in the money market
•How the money market reaches equilibrium.
•To make transactions
•To be prepared for contingencies—
accidents, lawsuits, e.g.
•To store wealth—as an alternative to
bonds, equities, jewelry, farmland, etc.
The Portfolio Decision: Money or Bonds?
•Bonds yield interest; money does not.
•The opportunity cost of holding money is given by
the interest that could have been earned by holding
bonds.
“Interest is the reward for parting with
liquidity.”
The Demand for Money (Md)
M  f ( P, Y , r )
d
Where:
•Md is the total demand for money
•P is the price level
•Y is real income (or GDP)
•r is the rate of interest (or percentage yield of
bonds).
Md is positively
related to P and Y,
ceteris paribus. Also,
Md is inversely
related to r, ceteris
paribus.
Interest
Rate
6%
Demand for Money
•As we move along Md, P and
Y are held constant.
E
•The movement from point E
to F is a change in the demand
for money as a store of value in
reaction to a decrease in the
yield of bonds.
F
3%
Md
0
500
800
Money
($Billions)
Interest
Rate
Effect of a Change in Price Level
(P) or Real GDP (Y)
Md1 Md2
•Increase in P, ceteris paribus.
6%
E
G
•Increase in Y, ceteris paribus
H
F
3%
Md1
0
500
700
800
1,000
Md2
Money
($Billions)
Bond Prices and the Rate Of
Interest
Bond prices and
interest rates (or
yields), move
inversely
Suppose you paid $800 for a bond that promises to pay $1,000
to its holder one year from today. What is the interest rate or
percentage yield of the bond? Notice first that your interest
income would be equal to $200. Hence to compute the yield, use
the following equation:
Yield (%) = (interest income/price of the bond)  100
Thus, we have:
Yield (%) = (200/800)  100 = 25 percent
Now suppose, instead of paying $800 for the bond, you paid
$900. What is the yield now?
Yield (%) = (100/900)  100 = 11 percent
To say the market is
“bullish” is to say that,
on average, people
forecast that interest
rates will decline;
hence bond prices are
heading up.
When people are
bearish, they expect
interest rates to rise, and
bond prices to fall.
Bullishness means people want to
hold less money as a store of value.
Bullishness results in a
decrease (shift to the left) of
the Md function as people
buy bonds in anticipation of
rising prices.
Interest Effects of Market Bearishness
Rate
6%
E
K
F
3%
Md2
Md1
0
500
800
Money
($Billions)
•The supply of money schedule reveals
the stock of money available to satisfy
the demand for money at various interest
rates.
•We assume the supply of money is
determined by the Federal Reserve
system or the Fed.
•The Fed can change the money supply
by adjusting reserve requirements, the
discount rate, or by open market
operations.
Interest
Rate
Supply of Money (Ms)
Ms 1
Ms 2
Ms1  Ms2
•Decrease of RRR
6%
E
•Open market
purchase of
government securities
J
3%
0
•Decrease of discount
rate
500
700
Money
($Billions)
Interest
Rate
7%
6%
Equilibrium in the Money market
Ms
•When r = 7%, Ms > Md by
$85 billion.
•When r = 3%, Md > Ms by
$300 billion.
E
•When r = 6%, Ms = Md
3%
Md
0
415 500
800
Money
($Billions)
When there is an excess supply of
money in the economy, there is also
an excess demand for bonds
Interest rate
higher than
equilibrium
Excess
supply of
money
Excess
demand
for
bonds
Public
buys
bonds
Price of
bonds
rises