Transcript Economics: Principles and Applications, 2e by Robert E. Hall & Marc

The Money Market
and the Interest Rate
© 2003 South-Western/Thomson Learning
The Demand for Money
•An Individual’s Demand for Money
•The Economy-Wide Demand
for Money
Individuals’ Demand for Money
Wealth Constraint
At any point in time, wealth is fixed
Individuals’ Demand for Money
An individual’s quantity of money
demanded is the amount of wealth
that the individual chooses to hold as
money, rather than as other assets.
Individuals’ Demand for Money
When you hold money, you bear an
opportunity cost - the interest you
could have earned.
Individuals’ Demand for Money
Individuals choose how to divide wealth
between two assets:
(1) money, which can be used as a means
of payment but earns no interest, and
(2) bonds, which earn interest but cannot
be used as a means of payment.
Individuals’ Demand for Money
How much money an individual will
decide to hold is determined by:
•The Price Level
•Real Income
•The Interest Rate
The Economy-Wide Demand
for Money
The amount of total wealth in the
economy that all households and
businesses together choose to hold as
money rather than as bonds
The Money Demand Curve
Money Demand Curve
A curve indicating how much
money will be willingly held at
each interest rate
The Money Demand Curve
Interest
Rate
The money demand curve
is drawn for a given real GDP
and a given price level.
At an interest rate of
6 percent, $500 billion
of money is demanded.
E
6%
F
3%
If the interest rate drops to
3 percent, the quantity of
money demanded increases
to $800 billion.
Md
500
800
Money
($ Billions)
Shifts in the Money Demand
Curve
A change in the interest rate moves us
along the money demand curve.
A change in money demand caused by
something other than the interest rate
(such as real income or the price level)
will cause the curve to shift.
Shifts in the Money Demand Curve
Interest
Rate
An increase in real GDP or in the
price level will shift the money
demand curve rightward.
At any interest rate, more
money will be demanded
after the shift.
6%
E
G
F
3%
H
d
M1
500
700 800 1,000
d
M2
Money
($ Billions)
Shifts in the Money Demand
Curve
Interest
Rate
Interest rate
moves us
leftward along
the money
demand curve
C
9%
A
6%
Interest rate
moves us
rightward along
the money
demand curve
Interest
Rate
Entire money
demand curve
shifts rightward
if the price level
or income
increases
B
3%
M 1d
300
500
800
Money
($ Billions)
M 1d
M 2d
Money
($ Billions)
The Supply of Money
Money Supply Curve
A line showing the total quantity of
money in the economy at each
interest rate
The Supply of Money
Interest
Rate
6%
3%
s
M1
s
M2
E
J
500
700
Money
($ Billions)
The Supply of Money
Open market purchases of bonds
inject reserves into the banking
system and shift the money supply
curve rightward by a multiple of the
reserve injection.
The Supply of Money
Open market sales have the opposite
effect: They withdraw reserves from
the system and shift the money
supply curve leftward by a multiple of
the reserve withdrawal.
Equilibrium in
the Money Market
Occurs when the quantity of money
people are actually holding (quantity
supplied) is equal to the quantity of
money they want to hold (quantity
demanded)
Money Market Equilibrium
Interest
Rate
Ms
9%
E
6%
3%
Md
300
500
800
Money
($ Billions)
How the Money Market
Reaches Equilibrium
Excess Supply of Money
The amount of money supplied exceeds the
amount demanded at a particular interest rate
Excess Demand for Bonds
The amount of bonds demanded exceeds the
amount supplied at a particular interest rate
How the Money Market
Reaches Equilibrium
When there is an excess supply of
money in the economy, there is also
an excess demand for bonds.
How the Money Market
Reaches Equilibrium
Interest
rate higher
than
equilibrium
Excess
supply of
money
Excess
demand for
bonds
Public tries
to buy
bonds
Prices of
bonds go up
Bond Prices and Interest Rates
When the price of bonds rises, the
interest rate falls.
When the price of bonds falls, the
interest rate rises.
How the Money Market
Reaches Equilibrium
Interest
rate higher
than
equilibrium
Excess
supply of
money and
excess
demand for
bonds
Public tries
to buy
bonds
Price of
bonds
goes up
Interest
rate goes
down
How the Money Market
Reaches Equilibrium
Interest
rate lower
than
equilibrium
Excess
demand for
money and
excess
supply of
bonds
Public tries
to sell
bonds
Price of
bonds go
down
Interest
rate goes
up
What Happens
When Things Change?
•How the Fed Changes the Interest Rate
•The Fed in Action
•How Do Interest Rate Changes Affect
the Economy?
•Fiscal Policy (and Other Spending
Changes) Revisited
Changes in the Interest Rate
1) What causes the equilibrium
interest rate to change?
2) What are the consequences of
a change in the interest rate?
How the Fed Changes the
Interest Rate
At point E, the money
market is in equilibrium at
an interest rate of 6 percent.
Interest
Rate
6%
s
M1
s
M2
To lower the interest rate, the
Fed could increase the money
supply to $800 billion.
The excess supply of money
(and excess demand for bonds)
would cause bond prices to rise,
and the interest rate to fall, until
a new equilibrium is established
at point F with an interest rate
of 3 percent.
E
F
3%
M
500
800
d
Money
($ Billions)
How the Money Market
Reaches Equilibrium
Fed
conducts
open
market
purchases
Money
supply
increases
Interest
rate goes
down
Excess
supply of
money and
excess
demand for
bonds
Price of
bonds
goes up
Public
tries to
buy
bonds
How the Money Market
Reaches Equilibrium
Fed
conducts
open
market
sales
Money
supply
decreases
Interest
rate goes
up
Excess
demand for
money and
excess
supply of
bonds
Public
tries to
sell
bonds
Price of
bonds
goes down
How the Fed Changes the
Interest Rate
•If the Fed increases the money supply by buying
government bonds, the interest rate falls.
•If the Fed decreases the money supply by selling
government bonds, the interest rate rises.
•By controlling the money supply through
purchases and sales of bonds, the Fed can also
control the interest rate.
The Fed in Action
Federal Funds Rate
The interest rate charged for loans of
reserves among banks
The Fed in Action
(a)
Money
($ Billions)
Money (M1)
During 2001, the Fed
repeatedly increased the
money supply
1,250
...
1,200
1,150
1,100
1,050
1,000
Aug.
2000
Dec.
2000
Apr.
2001
Aug.
2001
(b)
Percent
Dec.
2001
Year and Month
Federal Funds Rate
6.0
which caused the
interest rate to drop.
5.0
4.0
3.0
2.0
Aug.
2000
Dec.
2000
Apr.
2001
Aug.
2001
Dec.
2001
Year and Month
How Do Interest Rate Changes
Affect the Economy?
A drop in the interest rate will boost
several different types of spending
in the economy.
How the Interest Rate Affects
Spending
When the Fed increases the money supply, the
interest rate falls, and spending on three
categories of goods increases:
• plant and equipment,
• new housing, and
• consumer durables (especially automobiles).
When the Fed decreases the money supply, the
interest rate rises, and these categories of
spending fall.
Monetary Policy
and the Economy
(b)
(a)
Interest
Rate
6%
M 1s
M2s
Real
Aggregate
Expenditures
($ Trillions)
AE r = 4.5%
H
AE r = 6%
E
E
H
4.5%
d
MY = $10 trillion
3%
F
d
MY = $8 trillion
500
800
Money
($ Billions)
45º
8
10
Real GDP
($ Trillions)
Monetary Policy and the Economy
Open
market
sales
Money
supply
increases
Interest
rate goes
down
Multiplier
Real GDP
goes up
A and I D
go up
effect
Monetary Policy and the Economy
Open
market
sales
Money
supply
decreases
Interest
rate goes
up
Multiplier
Real GDP
goes down
A and I D
go down
effect
Fiscal Policy and Other
Spending Changes
(a)
Interest
Rate
8%
6%
M
(b)
Real
Aggregate
Expenditures
($ Trillions)
s
F
L
AEr = 8%
AEr = 6%
L
E
E
d
MY = $13.5
trillion
d
MY = $10 trillion
500
Money
($ Billions)
45°
10
13.5 15
Real GDP
($ Trillions)
Fiscal Policy and Other
Spending Changes
An increase in government
purchases, which by itself shifts the
aggregate expenditure line upward,
also sets in motion forces that shift it
downward.
Increase in Government
Purchases
Government Multiplier
GDP goes
purchases
up
go up
effect
GDP goes
down
Increase
in money
demand
Multiplier
effect
A and I D
go down
r goes up
Increase In Government
Purchases
In the short run, an increase in
government purchases causes real
GDP to rise, but not by as much as if
the interest rate had not increased.
Crowding Out
When effects in the money market are
included in the short-run macro model,
an increase in government purchases
raises the interest rate and crowds out
some private investment spending.
It may also crowd out consumption
spending.
Other Spending Changes
Increases in government purchases,
investment, and autonomous consumption, as
well as decreases in taxes, all shift the
aggregate expenditure line upward.
Real GDP rises, but so does the interest rate.
The rise in equilibrium GDP is smaller than if
the interest rate remained constant.
Other Spending Changes
Decreases in government purchases,
investment, and autonomous consumption, as
well as increases in taxes, all shift the
aggregate expenditure line downward.
Real GDP falls, but so does the interest rate.
The decline in equilibrium GDP is smaller
than if the interest rate remained constant.
Are There Two Theories
of the Interest Rate?
In the long run, we view the interest
rate as determined in the market for
loanable funds, where household
saving is lent to businesses and the
government.
Are There Two Theories
of the Interest Rate?
In the short run, we view the interest
rate as determined in the money
market, where wealth holders adjust
their wealth between money and
bonds, and the Fed participates by
controlling the money supply.
Expectations of the Fed
A general expectation that interest
rates will rise (bond prices will fall) in
the future will cause the money
demand curve to shift rightward in
the present.
Expectations of the Fed
Interest
Rate
M
s
10%
5%
E
M2d
M 1d
500
Money
($ Billions)