ECON 1113 1st Edition Lecture 18 Outline of Last Lecture I. The Government Bond MarketA. Bond Prices and Interest YieldsB. How It WorksC. Why Are There So Many Different Interest Rates?II. Money Demand (MD) or Liquidity PreferenceA. Motives for Holding (Demanding) MoneyB. Money Demand, Money Supply, and Interest Rate DeterminationOutline of Current Lecture I. Money Demand (MD) GraphicallyII. Interest Rate DeterminationIII. The Money Market and the Bond MarketIV. The Money Expansion MultiplierCurrent LectureI. I. Money Demand (MD) GraphicallyA. 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 paribusB. Diagram1. Horizontal axis: quantities of money balances/time2. Vertical axis: interest rate (i) in percent (%)3. The money demand curve (MD) mimics the common demand curve4. When interest is low, quantities of money balances are high and vise versaII. Interest Rate DeterminationA. i: opportunity cost of holding (demanding) money balances “price”III. The Money Market and the Bond MarketA. Money Market Diagram1. The axes and money demand curve are the same as the above description; however, a vertical money supply curve (MS) is present2. The point of equilibrium as it occurs on the vertical axis in the equilibriuminterest rate3. This is determined by the Fed operating through the commercial banking systemThese 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.B. Example: 1979-19811. Consider rates of change: % ∆ MS+% ∆V =% ∆ P+% ∆Q = 13% + 0% = 10% + 3%1. To combat double digit inflation, the Fed reduces rate of growth ofMS or % ∆ MS2. How to reduce % ∆ MSa. Fed sells bonds on the open marketb. A lower equilibrium bond price implies a higher interest ratec. A higher interest rate implies a lower bond price2. Money Market Diagram Shifts1. When the Fed sells more bonds, the vertical MS curve shifts to the left, raising the equilibrium interest rate2. The interest rate equilibrium of the money market implies the equilibrium of bond prices in the bond market and vice versa3. Bond Market Diagram Shifts1. Horizontal axis: quantity of bonds/time2. Vertical axis: price of bonds ($/bond)3. Typical demand and supply curves are present4. When the Fed sells more bonds, the original supply curve shifts to the right, lowering equilibrium bond priceC. Example: current1. Consider rates of change: % ∆ MS+% ∆V =% ∆ P+% ∆Q = 4% + 0% = 2% + 2%2. Policy makers seek to “stimulate” more real growth (increase % ∆Q)3. The Fed should increase % ∆ MS to lower interest rates (i) to increase employment and production in interest sensitive industries, like housing and automobiles because both rely on borrowed money4. The Fed can do this by purchasing bonds in the open market as instructedby the FOMC5. 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 bonds6. 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 rates7. Equilibriums of both bond price and interest rates imply one anotherIV. The Money Expansion MultiplierA. 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 bankB. Example1. $100 deposited implies some fraction of $100 is held in reserves2. Suppose $20 placed in reserves of the $1003. This implies $80 out of the original $100 available to be loaned4.∆ MS(maximum potential)=∆ Total Reserves∈the commercial banking system x (1required reserve ratio)5. The required reserve ratio (RRR) is set by the Fed as a legally required entity6.∆ TR=+$ 1 million and RRR = 20%7. 1000000 x (1/(1/5)) = +$50000008. Thus ∆ MS = +$5 million9.∆ MS max potential is only achieved if commercial banks loan all excess reserves; otherwise, the actual change is