Ch 14 The Money Market Monetary Policy The Demand for Money I The demand for money how much money people would like to hold given the constraints they face A A Household s Demand for Money Money is a form in which people hold they wealth When we want to hold wealth in the form of money we must less wealth in other forms People exchange one kind of wealth for another Wealth Constraint at any point in time total wealth is fixed A household s quantity of money demanded is the amount of wealth that the household chooses to hold as money rather than as assets Why do people want to hold some of their wealth in form of money money is a means of payment while other forms of wealth are not used for purchases However other forms of wealth provide a financial return to their owners Ex bonds saving deposits and time deposits pay interest while stocks pay dividends and may also rise in value which is called capital gain When you hold money you bear an opportunity cost the interest or other financial return you could have earned by holding other assets instead Must decide how to divide total wealth b t money and other assets Households choose how to divide wealth between 1 money which can be used as a means of payment but earns no interest and 2 other assets which earn interest or other financial returns but cannot be used as a means of payment Tradeoff more wealth held as money less often we have to go through changing our other assets into money but less interest we earn on our wealth What determines how much money each of us will decide to hold o The Price Level The greater number of dollars you spend in a typical month week the more money you will want to have on hand to make purchases A rise in price level which raises the dollar cost of your purchases should there fore increase the amount of money you want to hold o Real Income increases Suppose price level remains unchanged but income Once again you will spend more dollars in a typical week month so you will want to hold more of your wealth in the form of money o Interest Rate Interest payments and other financial returns is what you give up to hold money Interest rates the rate of return you earn by holding bonds and other similar assets The greater the interest rate the greater the opportunity cost of holding money Ch 14 The Money Market Monetary Policy Thus a rise in the interest rate decreases your quantity of money demanded 1 Nominal vs Real Interest Rates Real interest rate what people care about when making decisions about spending or saving Which interest rate tells us the opportunity cost of saving money Ex imagine you must decided whether to hold 1 000 as money or in some other asset that pays a nominal interest rate of 10 You know the inflation rate for the year is going to be 10 The real interest rate on asset calculated by subtracting the rate of inflation from the nominal interest rate will be zero Is 0 or 10 the opportunity cost of holding money If you hold the 1000 as money at the end of ear you will have exactly 1000 but you will have lost 10 of its purchasing power due to inflation On other hand if you hold the interest earning asset you will have 1 100 which means your purchasing power will be the same as it was in the beginning of the year The money leaves you with 10 less purchasing power than the interest earning asses The nominal interest rate tells us the opportunity cost of holding money B The Economy Wide Demand for Money In addition to households money also demanded by business Businesses face same type of constraints as individuals Quantity of money demanded by businesses follows same principles as households o When price level rises businesses want to hold more money b c each transaction they engage in will involve more dollars o As real income in the economy rises businesses want to hold more money b c they will be buying and selling more goods and services each day o A rise in nominal interest rates will decrease business demand for money b c they will prefer to hold more interest earning assets instead The Quantity of Money Demanded is the amount of total wealth in the economy that all households and business together want to hold as money rather than other assets Demand for money in economy depends on 3 variables 1 a rise in price level will increase demand for money 2 a rise in real income real GDP will increase the demand for money and 3 a rise in nominal interest rates will decrease the quantity of money demanded C Demand for Money w a Single Interest Rate 1 The Money Demand Curve Money Demand Curve tells us the total quantity of money demanded in the economy at each nominal interest rate Curve is downward sloping As long as other influences on money demand don t change a drop in interest rate which lowers opportunity cost of holding money will increase the quantity of money demanded Ch 14 The Money Market Monetary Policy What happens when something other than interest rate changes the quantity of 2 Shifts in the Money Demand Curve money demanded the curve shifts Ex suppose real income or price level increases Then at each interest rate households and businesses will want to hold more of their wealth in the form of money The entire money demand curve will shift rightward In general a change in the interest rate moves us along the money demand curve A change in money demanded caused by something other than the interest rate such as real income or the price level will cause the curve to shift Ch 14 The Money Market Monetary Policy II The Supply of Money The supply of money is the amount of money cash and demand deposits that the Fed and the banking system have created What determines the quantity Fed Assume that the money supply regardless of if interest rate rise or fall will remain 1 in Figure 4 is money supply curve shows the total amount of money supplied at each interest constant unless Fed decides to change it The vertical line MS Money Supply Curve rate Line is vertical b c once the Fed sets the money supply it remains constant until the Fed changes it In figure Fed has chosen money supply at 1000 billion A rise in the interest rate from 3 to 6 would move us from point J to E along the 1 leaving money supply unchanged money supply curve MS Ch 14 The Money Market Monetary Policy Suppose Fed were to change the money supply there would be a new vertical line showing different quantity of money supplied at each interest rate Ex if money multiplier is 10 and the Fed purchases government bonds worth
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