1

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?– Transactions demand– Precautionary demand– Speculative demand

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

Figure 1: The Money Demand Curve

6

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

7

Figure 2: A Shift in the Money Supply Curve

8

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

9

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.

10

Figure 4: The Supply of Money

700

M2s

Money ($ Billions)

Interest Rate

6%E

J

500

3%

M1s

11

Figure 5: Money Market Equilibrium

12

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

13

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

14

Figure 6: An Increase in the Money Supply

15

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

16

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

• 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

17

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

18

Figure 7: Interest Rate Expectations