Financial MarketsHow Is the Interest Rate Determined in the Short Run?The Demand for MoneySlide 4Slide 5Deriving the Demand for MoneySlide 9The Determination of the Interest Rate, Part ISlide 11Money Demand, Money Supply; and the Equilibrium Interest RateSlide 13The Demand for Money and the Interest Rate: The EvidenceSlide 15Slide 16Slide 17Slide 18Monetary Policy and Open-Market OperationsSlide 20Slide 21Slide 22Slide 23Slide 24What did I learn in this chapter?Prepared by:Prepared by:Fernando Quijano and Yvonn QuijanoFernando Quijano and Yvonn QuijanoAnd Modified by Gabriel MartinezAnd Modified by Gabriel Martinez44C H A P T E RC H A P T E RFinancial MarketsFinancial Markets© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier BlanchardHow Is the Interest Rate How Is the Interest Rate Determined in the Short Run?Determined in the Short Run?How Is the Interest Rate Determined in the How Is the Interest Rate Determined in the Short Run?Short Run?By the condition that the supply of money By the condition that the supply of money equals the demand for money.equals the demand for money.–Here, there are only two assets: bonds and money.Here, there are only two assets: bonds and money.–Here, nominal income and prices are given, so there Here, nominal income and prices are given, so there is no need to consider simultaneous equilibrium of is no need to consider simultaneous equilibrium of goods and financial markets.goods and financial markets.Investment is a function of the interest rate, so Investment is a function of the interest rate, so output is affected by the interest rate.output is affected by the interest rate.Monetary policy is, in large part, directed to the Monetary policy is, in large part, directed to the determination of the interest rate. determination of the interest rate.© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier BlanchardThe Demand for MoneyThe Demand for MoneyMoneyMoney,, which can be used for transactions, pays which can be used for transactions, pays no interest. There are two types of money: no interest. There are two types of money: currencycurrency and and checkable depositscheckable deposits..BondsBonds,, pay a positive interest rate, pay a positive interest rate, ii, but they , but they cannot be used for transactions.cannot be used for transactions.Wealth = Money + BondsWealth = Money + Bonds–How much of your saving should you hold as money? How much of your saving should you hold as money? Depends on your level ofDepends on your level oftransactionstransactionsand the and the interest rate on bondsinterest rate on bonds. . 4-1© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier BlanchardThe Demand for MoneyThe Demand for MoneyTransactionsTransactions Demand for Money Demand for Money–You need money (a financial asset that is an You need money (a financial asset that is an accepted medium of exchange) to buy goods accepted medium of exchange) to buy goods and services on a day to day basis.and services on a day to day basis.Buying food, paying the rent, filling up the tank.Buying food, paying the rent, filling up the tank.–Higher pricesHigher prices increase the demand for increase the demand for money.money.–Higher incomeHigher income increases the demand for increases the demand for money.money. MMdd is is directlydirectly proportional to proportional to nominal income.nominal income.© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier BlanchardThe Demand for MoneyThe Demand for MoneyThe The interest rate on bondsinterest rate on bonds–People prefer to hold liquid assets, i.e., means People prefer to hold liquid assets, i.e., means of exchange.of exchange.–To get them to hold bonds (which are not To get them to hold bonds (which are not liquid), people must be paid interest.liquid), people must be paid interest.–Money doesn’t pay interest.Money doesn’t pay interest.–If the interest rate is high, the opportunity cost If the interest rate is high, the opportunity cost of holding money is higher.of holding money is higher.–There’s an inverse relation There’s an inverse relation LL((ii) between the ) between the holding of liquid assets and the interest rate.holding of liquid assets and the interest rate.© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier BlanchardDeriving the Demand for MoneyDeriving the Demand for MoneyThe demand for The demand for money:money:–increases in proportion increases in proportion to to nominal incomenominal income, , $Y$Y, , andand–depends negatively on depends negatively on the interest rate: the interest rate: LL((ii).).)($ iYLMd© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier BlanchardDeriving the Demand for MoneyDeriving the Demand for MoneyFor a given level of nominal income ( for a for a given Mgiven Mdd curve curve)), a lower interest rate increases the quantity demanded of money.At a given interest rate, an increase in nominal income shifts the demand for money to the right.The Demand for MoneyThe Demand for Money© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier BlanchardThe Determination ofThe Determination ofthe Interest Rate, Part Ithe Interest Rate, Part IIn this section, we assume that people only In this section, we assume that people only hold money in the form of currency.hold money in the form of currency.Then only the central bank supplies money, Then only the central bank supplies money, in an amount equal to M, so in an amount equal to M, so MM = = MMss. . –The role of banks as suppliers of money (in the The role of banks as suppliers of money (in the form of checkable deposits) is introduced in the form of checkable deposits) is introduced in the next section. next section.