Chapter 14 The Demand for Money face A Household s Demand for Money How much money people would like to hold given the constraints that they If we want to hold more wealth in the form of money we must hold less wealth in other forms savings accounts money market funds time deposits stocks bonds Individual s wealth constraint determined by o Wealth at any moment is given o You must give up one kind of wealth in order to acquire more of another A household s quantity of money demanded is the amount of wealth that the household chooses to hold as money rather than as other assets People want to hold some wealth in form of money bc o Money is a means of payment When you hold money you bear an opportunity cost the interest or other financial return you could have earned by holding other assets instead Money pays little or no interest Households choose how to divide wealth between o Money which can be used as a means of payment but earns no o Other assets which earn interest or other financial returns but cannot be used as a means of payment Three variables that determine how much money we decide to hold o The price level A rise in the price level increases amount you want interest to hold o Real income If income increases want to hold more money o The interest rate A rise in the interest rate decreases your quantity of money demanded Nominal vs Real Interest Rates The Economy Wide Demand for Money The nominal interest rate tells us the opportunity cost of holding money Businesses also face constraints they only have so much wealth and they must decide how much of it to hold as money rather than other assets The quantity of money demanded is the amount of total wealth in the economy that all households and businesses together want to hold as money rather than other assets Demand for Money with a Single Interest Rate The Money Demand Curve Money demand curve tells us the total quantity of money demanded in the economy at each nominal interest rate Down sloping a drop in the interest rate which lowers the opportunity cost of holding money will increase the quantity of money demanded Shifts in the Money Demand Curve demanded the curve shifts When something other than the interest rate changes the quantity of money o Ex if real income or price level increases households and businesses will want to hold more of their wealth at each interest rate A change in the interest rate moves us along the money demand curve A change in money demand caused by something other than the interest rate such as real income or the price level will cause the curve to shift 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 o The Fed can use open market operations to inject or withdraw reserves from the banking system and rely on the money multiplier to do the rest o The interest rate can rise or fall but the money supply will remain constant unless and until the Fed decides to change it Money supply curve shows the total amount of money supplied at each interest rate o Vertical once the Fed sets the money supply it remains constant until the Fed changes it o If the Fed changed the money supply there would be a new vertical line Equilibrium in the Money Market Equilibrium interest rate the interest rate at which the quantity of money demanded and the quantity of money supplied are equal o When the quantity of money people are actually holding quantity supplied is equal to the quantity of money they want to hold quantity demanded How the Money Market Reaches Equilibrium If people were actually holding 1 000 billion of their wealth as money but they would want to hold only 600 billion as money there would be an excess supply of money o The quantity of money supplied would exceed the quantity demanded If people want to hold less money than they are currently holding then they must want to hold more in bonds then they currently are an excess demand for bonds When there is an excess supply of money in the economy there is also an excess demand for bonds An Important Detour Bond Prices and Interest Rates A bond is a promise to pay back borrowed funds at a certain date or dates in When the price of bonds rises the interest rate falls when the price of bonds the future falls the interest rate rises Back to the Money Market As long as there continues to be an excess supply of money and an excess demand for bonds the public will still be trying to acquire bonds and the interest rate wil continue to fall As the interest rate falls the quantity of money demanded rises If the interest rate is higher than the equilibrium rate an excess supply of money and an excess demand for bonds causes the price of bonds to rise so the interest rate falls If the interest rate is lower than the equilibrium rate an excess demand for money and an excess supply of bonds causes the prices of bonds to fall so the interest rate rises Are There Two Theories of the Interest Rate The public continuously chooses how to divide its wealth between money and bonds What Happens When Things Change How the Fed Can Change the Interest Rate To change the interest rate the Fed must change the equilibrium interest rate in the money market by changing the money supply To lower the interest rate the Fed increases the money supply through open To raise the interest rate the Fed decreases the money supply through open market purchases of bonds market sales of bonds By controlling the money supply through purchases and sales of bonds the Fed can also control the interest rate How Do Interest Rate Changes Affect the Economy A drop in the interest rate will boost several different types of spending in the economy equipment o A lower interest rate stimulates business spending on plant and The Interest rate is the opportunity cost of the firm s own funds when they are spent on plant and equipment A drop in the interest rate will cause an increase in spending in plant and equipment Interest rate changes also affect spending on new hones and apartments When the Fed increases the money supply the interest rate falls and spending on three categories of goods increases plant and equipment new housing and consumer durables especially automobiles When the Fed decreases the money supply the interest rate rises and these categories of spending fall Monetary Policy The Fed through its control of the interest rate has the power to influence real GDP When the Fed exercises this power it is
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