MONEY AND THE

DETERMINATION OF

INTEREST RATEDongpeng Liu

Department of Economics

Nanjing University

ROADMAP

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INCOME

EXPENDITURE

LIQUIDITY

PREFERENCE

IS

CURVE

LM

CURVE

AGGREGATE

DEMAND

SHORT-RUN

LABOR

MARKET

AGGREGATE

SUPPLY

AS-AD

MODEL

IS-LM

MODEL

PHILLIPS

CURVE

INTERMEDIATE-RUN

SOLOW

MODEL

LONG-RUN w/

CAPITAL

ACCUMULATION

LONG-RUN

AS-AD

MODEL

LONG-RUN w/o

CAPITAL

ACCUMULATION

MONEY

Money is an asset that can be easily used for transactions

Functions of money

Medium of exchange: Money is what we use to buy goods and services. The ease

with which an asset can be converted in to the medium of exchange and used

to buy goods and services is called the asset’s liquidity.

Store of value: Money is a way to transfer purchasing power from the present

to the future.

Unit of account: Money provides the terms in which prices are quoted and

debts are recorded.

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TYPE OF MONEY

Money that has no intrinsic value is called fiat money because

it is established as money by government decree, or fiat.

e.g., RMB, US dollars, Japanese yen, Euro etc.

If not widely accepted, fiat money bills are just pieces of paper

Most societies in the past have used a commodity with some

intrinsic value for money, which is called commodity money.

e.g., gold, silver, copper.

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THE DEVELOPMENT OF FIAT MONEY

1. People carry around bags of

gold

When a purchase is made, the

buyer measures out the

appropriate amount of gold

If the seller is convinced that

the weight and purity of the

gold are right, the buyer and

seller make the exchange

High transaction cost (Why?)

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2. The government gets

involved in the monetary

system to help reduce

transaction costs

The government can mint gold

coins of known purity and

weight

Values of gold coins are

widely recognized

Lower transaction costs

THE DEVELOPMENT OF FIAT MONEY

3. Government accepts gold from

the public in exchange for

gold certificates

If people believe the

government’s promise to redeem

paper bill for gold, the bills

are as valuable as the gold

Bills are lighter than gold and

easier to use. (Even lower

transaction costs)

No one carries gold around at

all. Gold-backed government

bills become the monetary

standard.

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4. Gold backing becomes

irrelevant

No one bothers to redeem the

bills for gold

No one cares if the option is

abandoned as long as paper

bills are widely accepted for

exchange.

Commodity money system evolves

into fiat money system.

HOW THE QUANTITY OF MONEY IS MEASURED

Different countries use different measures

M0: Currency

M1: M0 + checkable deposits

M2: M1 + saving deposits + time deposits

Which of the following is a part of money balance?

Balance in your debit card

Credit card balance

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MONEY vs. BONDS

For simplicity, assume there are two types of financial assets

Money

Bonds

Money can be used for transactions, but we do not receive interest payment by holding money.

Bonds can not be used to buy goods and services, but we can receive interest payment from bonds. In reality, there are more than 1 kinds of bonds and different interest rates due to bonds’ different liquidities and levels of risk. For simplicity, we assume there is only 1 type of bonds and 1 interest rate.

Interest rate (i) is the cost of holding 1 unit of money.

People need to consider the tradeoff between convenience and returns

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MONEY DEMAND: LIQUIDITY PREFERENCE THEORY

Money demand depends on

Amount of transactions: The more money needed for transactions, the more

money is held.

Interest rate: Higher interest rate → Higher cost of holding money → Lower

money demand

𝑀 = 𝑃𝑌𝐿(𝑖) or 𝑀

𝑃= 𝑌𝐿(𝑖)

P: general price level

Y: real GDP

PY: total amount of transactions

M/P: real money demand and real money balance

L(i): a decreasing function of interest rate

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MONEY DEMAND CURVE

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MONEY DEMAND CURVE

Real money balance is on the horizontal axis

Interest rate is on the vertical axis

Money demand curve is downward sloping

As interest rate changes, quantity of real money demanded moves

along the money demand curve

For any given interest rate, an increase in Y will lead to an

increase in real money demand, causing the money demand curve

to shift to the right

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MONEY SUPPLY CURVE

(Real) money supply is determined by the central bank. (Money

supply is exogenous)

Money supply curve is a vertical line.

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HOW MONEY SUPPLY IS CONTROLLED

The primary way in which the central bank controls the supply

of money is through open market operations

Open market operations: The purchase and sale of government

bonds by the central bank

If central bank purchases bonds in the bonds market, then the

sellers of bonds (the public) will receive money and money

supply increases. This is called expansionary open market

operation.

If central bank sells bonds in the bonds market, then the

buyers of bonds (the public) will pay with money and money

supply decreases. This is called contractionary open market

operation.

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EQUILIBRIUM IN THE MONEY MARKET AND THE

DETERMINATION OF EQUILIBRIUM INTEREST RATE

If at a certain interest rate, (real) money demand equals (real)

money supply, the money market is in equilibrium and the

interest rate is the equilibrium interest rate

We can figure out the equilibrium interest rate by finding the

intersect of the money demand curve and money supply curve

If there is an increase in money supply, there will be excess

supply of money

Interest rate drops

Equilibrium in the money market is restored

Controlling money supply and controlling interest rate are the

two sides of the same coin

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EQUILIBRIUM IN THE MONEY MARKET AND THE

DETERMINATION OF EQUILIBRIUM INTEREST RATE

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SUMMARY

Money

Money demand: liquidity preference theory

Money supply and open market operations

Money market equilibrium and the determination of equilibrium

interest rate

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