UMD ECON 201 - Chapter 11: Money Demand and the Equilibrium Interest Rate

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Chapter 11: Money Demand and the Equilibrium Interest Rate Interest Rates and Bond Prices - Interest: the fee that borrowers pay to lenders for the use of their funds- Bonds are more complicated than loans o Bonds are issued with a face valueo Bonds come with a maturity date which is the day the borrower agrees to pay the lender the face value of the bondo Bonds have a fixed payment of a specified amount that is paid to the bondholder each year (known as a coupon) - Market determined prices of existing bonds and interest rates are inversely related >> just bc the coupon of a bond is unchanged over time does not mean that a bond’s price is safe from interest rate movements >> when interest rates rise, the prices of existing bonds falls - Bond market directly determines prices of bonds, not interest rates >> interest rates are indirectly determined by the bond market >> given a bond’s market determined price, its face value, its maturity, and its coupon, the interest rate on that bond can be calculated The Demand for Money - Interest rate and nominal income influence how much money households and firms choose to hold - We are interested in how much money ppl hold in the form of money (not earning interest) NOT how much money ppl keep in the bank (earning interest) - Transaction motive: the main reason that ppl hold money is to buy things o Assumptions 2 kinds of assets available to households: bonds and money Income arrives at the beginning of the month and is spent through out the month >> nonsynchronization of income and spending: the mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses  Spending for month = income for month o Average balance: income at beginning of month (1200) + income at end of month (0) divided by 2 o Trade off problem: there are brokerage fees and other costs to buy or sell bonds and time must be spent waiting in line at the bank or ATM but at the same time it is costly to hold assets in non-interest bearing form bc they lose potential interest revenue  Switching more often from bonds to money raises the interest revenue but increases his money management costs o Optimal balance: level of average money that earns the most profit taking into account both the interest earned on bonds and the cost paid for switching from bonds to moneyo Increase in increase rate lowers the optimal money balance o Interest rate represents the opportunity cost of holding money  The higher the interest rate, the higher the opportunity cost of holding money and the less money ppl will want to holdo Inverse relationship between interest rate and the quantity of money demanded - Speculation motive: one reason for holding bonds instead of money; bc the market price of interest bearing bonds is inversely related to the interest rate, investors may want to hold bonds when interest rates are high with the hope of selling them when the interest rate falls - P=aggregate price level - Y=real output- P*Y= nominal output and income - Theory of demand for money: everything is in nominal terms - Demand for money curve shifts out when nominal income rises The Equilibrium Interest Rate - The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy - Fed uses its 3 tools (RRR, discount rate, open market operations) to achieve its fixed target for the money supply >> money supply curve is vertical o When the Fed fixes the money supply, it also fixes the supply of bonds- When interest rates are higher than the equilibrium rate, there is an excess demand for bonds>> bid the price of bonds up and thus the interest rate down - When interest rate are lowers than the equilibrium rate, firms and households want to hold fewer bonds than the Fed is supplying >> bid the price of bonds down and thus the interest rate up - Increasing/decreasing supply of money affects interest rate o An increase in the supply of money lowers the interest rate & the supply of bonds is decreasing which drives up the price of bondso If the Fed wanted to increase the interest rate, it would contract the money supply - Increasing/decreasing nominal income (P*Y) affects interest rateo Increase in nominal income shifts the money demand curve to the right which raises the equilibrium interest rate - Fed cannot drive the interest rate lower than 0; at 0 people are indifferent about holding money or getting interest on it - Tight monetary policy: Fed policies that contract the money supply and thus raise interest rates in an effort to restrain the economy - Easy monetary policy: Fed policies that expand the money supply and thus lower interest rates in an effort to stimulate the

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UMD ECON 201 - Chapter 11: Money Demand and the Equilibrium Interest Rate

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