ECON 1113 1st Edition Lecture 18 Outline of Last Lecture I The Government Bond Market A Bond Prices and Interest Yields B How It Works C Why Are There So Many Different Interest Rates II Money Demand MD or Liquidity Preference A Motives for Holding Demanding Money B Money Demand Money Supply and Interest Rate Determination Outline of Current Lecture I Money Demand MD Graphically II Interest Rate Determination III The Money Market and the Bond Market IV The Money Expansion Multiplier Current Lecture I II III I Money Demand MD Graphically A There is an inverse relationship between the quantity of money balances demanded based on transactions precautionary and speculative motives and the interest rate i ceteris paribus B Diagram 1 Horizontal axis quantities of money balances time 2 Vertical axis interest rate i in percent 3 The money demand curve MD mimics the common demand curve 4 When interest is low quantities of money balances are high and vise versa Interest Rate Determination A i opportunity cost of holding demanding money balances price The Money Market and the Bond Market A Money Market Diagram 1 The axes and money demand curve are the same as the above description however a vertical money supply curve MS is present 2 The point of equilibrium as it occurs on the vertical axis in the equilibrium interest rate 3 This is determined by the Fed operating through the commercial banking system These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute IV B Example 1979 1981 1 Consider rates of change M S V P Q 13 0 10 3 1 To combat double digit inflation the Fed reduces rate of growth of MS or M S 2 How to reduce M S a Fed sells bonds on the open market b A lower equilibrium bond price implies a higher interest rate c A higher interest rate implies a lower bond price 2 Money Market Diagram Shifts 1 When the Fed sells more bonds the vertical MS curve shifts to the left raising the equilibrium interest rate 2 The interest rate equilibrium of the money market implies the equilibrium of bond prices in the bond market and vice versa 3 Bond Market Diagram Shifts 1 Horizontal axis quantity of bonds time 2 Vertical axis price of bonds bond 3 Typical demand and supply curves are present 4 When the Fed sells more bonds the original supply curve shifts to the right lowering equilibrium bond price C Example current 1 Consider rates of change M S V P Q 4 0 2 2 2 Policy makers seek to stimulate more real growth increase Q 3 The Fed should increase M S to lower interest rates i to increase employment and production in interest sensitive industries like housing and automobiles because both rely on borrowed money 4 The Fed can do this by purchasing bonds in the open market as instructed by the FOMC 5 Within the bond market such changes would shift the demand curve to the right due to the Fed buying up bonds thus raising the equilibrium price of bonds 6 Within the money market such changes would shift the MS curve to the right due to the Fed buying up bonds thus lowering the equilibrium of interest rates 7 Equilibriums of both bond price and interest rates imply one another The Money Expansion Multiplier A Commercial banks profit seeking institutions operate on a fractional reserve basis the commercial bank hold in reserves only a fraction of the money deposited in the bank B Example 1 100 deposited implies some fraction of 100 is held in reserves 2 Suppose 20 placed in reserves of the 100 3 This implies 80 out of the original 100 available to be loaned 4 M S maximum potential Total Reserves the commercial banking system x 5 The required reserve ratio RRR is set by the Fed as a legally required entity 6 TR 1 million and RRR 20 7 1000000 x 1 1 5 5000000 8 Thus M S 5 million 9 M S max potential is only achieved if commercial banks loan all excess reserves otherwise the actual change is less 1 required rese