Download Money Demand Curve

Financial Sector: Money Market
AP Economics
Mr. Bordelon
Demand for Money
• When we talk about the demand for money, we
must also discuss the opportunity cost of holding
money.
• If you are not spending money, you’re just
hanging on to it. Instead, you could save the
money in a bank account.
• You can use the money to make purchases, but it
earns no interest.
Demand for Money
• Katie could put $100 in a 12-month CD that
would earn 5%. CDs are illiquid because if you
withdraw the money before the period, you
forfeit most of the interest.
• If Katie keeps the $100 in her pocket or in her
checking account (M1), the opportunity cost is
5% or $5. This doesn’t really create an incentive
for Katie to keep the money in her pocket.
Demand for Money
• What if the interest rate was 50%? Would Katie
keep the $100 when that opportunity cost is now
$50?
• If the interest rate was 0.5%, how likely is it that
Katie would put the $100 in a CD?
Demand for Money
• The higher the short-term interest rate,
the higher the opportunity cost of holding
money.
• The lower the short-term interest rate,
the lower the opportunity cost of holding
money.
Demand for Money
• Why short term?
▫ Katie needs money to make transactions in the
short-term. Keeping money in a CD for 10 years
wouldn’t be appealing.
▫ Therefore, opportunity cost is focused on the short
term, not long term.
Money Demand Curve
Money Demand Curve
Notice the interest rate. Remember,
we’re talking about the short term. This
is the nominal interest rate.
People demand money to make
purchases in the short-term. The
opportunity cost of holding money
is the short-term interest rate.
Assumption: In the short term, there
will be virtually no inflation. Therefore,
the nominal interest rate is equal to the
real interest rate.
AP Note: Be careful how you label this
graph. For safety’s sake, on this graph,
label the y-axis as “nominal interest
rate.”
Money Demand Curve
This curve follows the law of demand.
When interest rates increase, the
opportunity cost of holding money
increases, and the quantity of money
demanded decreases.
When interest rates decrease, the
opportunity cost of holding money
decreases, and the quantity of money
demanded increases.
Here, we’re talking about a movement
along the money demand curve.
Shifts of the
Money Demand Curve
Changes in APL. Higher prices
increases demand for money (shift
right). Lower prices decreases demand
for money (shift left).
The demand for money is proportional
to price level. If APL increases by 20%,
QMONEY demanded at any given interest
rate also increases by 20%.
If the price of everything increases by
20%, it takes 20% more money to buy
the same amount of g/s.
Shifts of the
Money Demand Curve
Changes in real GDP
• Economy gets stronger, real incomes
and real GDP increase.
• The larger the quantity of g/s
bought, the larger QMONEY needed to
buy those goods at any given interest
rate.
• An increase in real GDP shifts MD
right.
•
•
•
Economy gets weaker, real incomes
and real GDP decrease.
People are buying less g/s. Less
QMONEY is needed to buy any g/s at
any given interest rate.
A decrease in real GDP shifts MD
left.
Shifts of the
Money Demand Curve
Changes in technology. Advances in
technology can reduce MD by making it
easier for the public to make purchases
without holding significant sums of
money
Debit cards are a good example of our
reduced need for money. And they have
caused MD to shift left.
Shifts of the
Money Demand Curve
Changes in institutions
• Regulations that make it more
attractive to keep money in banks
will reduce MD.
• MD shifts left.
•
•
Political and banking instability can
increase MD because people would
rather hoard money than store it in
banks that could be taken over or
fail.
MD shifts right.
Money and Interest Rates
• The Fed uses monetary policy to achieve a target
for the federal funds rate. Most interest rates
move with the federal funds rate.
• We use the liquidity preference model to
illustrate how the money market is affected by
monetary policy.
Liquidity Preference Model
First off, it’s important to understand
that MS is something set by the Federal
Reserve. It will be a given on the exam.
MS is independent of the interest rate,
and this explains the vertical curve. It
will not change with the interest rate.
rE is the equilibrium interest rate.
•Interest rates increase to rH.
•QMONEY of MS exceeds QMONEY of MD.
•High interest rates attract savers.
•Banks can actually lower the interest
rates on CDs and still have savers.
•Falling interest rates cause the QMONEY
demanded to fall back to equilibrium.
Liquidity Preference Model
rE is the equilibrium interest rate.
• Interest rates decrease to rL.
• QMONEY of MD exceeds QMONEY of
MS.
• Lower interest rates repel savers.
• Banks should increase the interest
rates on CDs to attract savers.
• Increasing interest rates cause the
QMONEY demanded to increase back
to equilibrium.
Question 1
• Congressional Research Service estimates that at least $45 million
of counterfeit U.S. $100 notes produced by the North Korean
government are in circulation.
▫ Why do taxpayers lose because of North Korea’s counterfeiting?
(HINT: draw a liquidity preference model with two MS
curves…the first where MS would be from the Fed, the second
with that curve plus the $45 million).
▫ As of September 2011, the interest rate earned on one year U.S.
Treasury bills was 2.2.%. At a 2.2% rate of interest, what is the
amount of money U.S. taxpayers are losing per year because of
these $45 million in counterfeit notes. (HINT: nominal interest
rate = real interest rate; do a change equation between what you
would earn at the equilibrium interest rate and the new interest
rate)