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The Money Market and the
Interest Rate
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
The Demand For Money
• Don’t people always want as much money as
possible?
– Yes
• But when we speak about demand for something,
we don’t mean amount people would desire if they
could have all they wanted
– Without having to sacrifice anything for it
– Demand for money does not mean how much money
people would like to have in best of all worlds
• Rather, it means how much money people would like to hold,
given constraints they face
2
An Individual’s Demand for Money
• At any given moment, total amount of wealth we have is
given
– If we want to hold more wealth in form of money, we must hold less
wealth in other forms
• These two facts determine an individual’s wealth
constraint
• An individual’s quantity of money demanded
– Amount of wealth individual chooses to hold as money
• Rather than as other assets
• Why do people want to hold some of their wealth in form of
money?
– Money is a means of payments
– Other forms of wealth provide a financial return to their owners
– Money pays either very little interest or none at all
• When you hold money, you bear an opportunity cost
– Interest you could have earned
3
An Individual’s Demand for Money
• Individuals choose how to divide wealth between two
assets
– Money, which can be used as a means of payment but earns no
interest
– Bonds, which earn interest, but cannot be used as a means of
payment
• What determines how much money an individual will
decide to hold?
– While tastes vary from person to person, three key variables have
rather predictable impacts on most of us
• Price level
• Real income
• Interest rate
• When we add up everybody’s behavior, we find a
noticeable and stable tendency for people to hold less
money when it is more expensive to hold money
– When the interest rate is higher
4
The Demand for Money by
Businesses
• Some money is held by businesses
– Stores keep some currency in their cash registers
– Firms generally keep funds in business checking
accounts
• They have only so much wealth, and they must
decide how much of it to hold as money rather
than other assets
• They want to hold more money when real income
or price level is higher
– Less money when opportunity cost (interest rate) is
higher
5
The Economy-Wide Demand For
Money
• Just as each person and each firm in economy has only so
much wealth
– There is a given amount of wealth in the economy as a whole at
any given time
– Total wealth must be held in one of two forms
• Money or bonds
• Economy-wide quantity of money demanded
– Amount of total wealth all households and businesses, together,
choose to hold as money rather than as bonds
• Demand for money depends on the same three variables
that we discussed for individuals
– A rise in the price level »» increased demand for money
– A rise in real income (real GDP) »» increased demand for money
– A rise in interest rate »» decreased demand for money
6
The Money Demand Curve
• Figure 1 shows a money demand curve
– Tells us total quantity of money demanded in
economy at each interest rate
– Curve is downward sloping
– As long as other influences on money demand
don’t change
• A drop in interest rate—which lowers the opportunity
cost of holding money—will increase quantity of
money demanded
7
Figure 1: The Money Demand
Curve
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Shifts in the Money Demand Curve
• What happens when something other than
interest rate changes quantity of money
demanded?
– Curve shifts
• A change in interest rate moves us along
money demand curve
9
Figure 2: A Shift in the Money
Supply Curve
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Figure 3: Shifts and Movements Along the
Money Demand Curve—A Summary
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The Supply of Money
• Just as for money demand, we would like to draw a curve
showing quantity of money supplied at each interest rate
– Interest rate can rise or fall, but money supply will remain constant
unless and until Fed decides to change it
• Suppose Fed, for whatever reason, were to change money
supply
– Would be a new vertical line
• Showing a different quantity of money supplied at each interest rate
• Open market purchases of bonds inject reserves into
banking system
– Shift money supply curve rightward by a multiple of reserve
injection
– Open market sales have the opposite effect
• Withdraw reserves from system
– Shift money supply curve leftward by a multiple of reserve withdrawal
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Figure 4: The Supply of Money
Interest
Rate
6%
3%
s
M1
s
M2
E
J
500
700
Money
($ Billions)
13
Equilibrium in the Money Market
• Key Step #3
– Combines what you’ve learned about money demand and money
supply to find equilibrium interest rate in economy
• We are interested in how interest rate is determined in
short-run
• In short-run we look for the equilibrium interest rate in
money market
– Interest rate at which quantity of money demanded and quantity of
money supplied are equal
• Important to understand what equilibrium in money market
actually means
– Remember that money supply curve tells us quantity of money that
actually exists in economy
• Determined by Fed
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Equilibrium in the Money Market
• Money demand curve tells us how much money
people want to hold at each interest rate
• Equilibrium in money market occurs when quantity
of money people are actually holding (quantity
supplied) is equal to quantity of money they want
to hold (quantity demanded)
• Can we have faith that interest rate will reach its
equilibrium value in money market?
– Yes
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Figure 5: Money Market Equilibrium
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How the Money Market Reaches
Equilibrium
• If people want to hold less money than they are currently
holding, then, by definition
– They must want to hold more in bonds than they are currently
holding
• An excess demand for bonds
• When there is an excess supply of money in economy
– There is also an excess demand for bonds
• Can illustrate steps in our analysis so far as follows
Conclude that, when interest rate is higher than its equilibrium
value, price of bonds will rise
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An Important Detour: Bond Prices
and Interest Rates
• A bond, in the simplest terms, is a promise to pay back
borrowed funds at a certain date or dates in the future
– When a large corporation or government wants to borrow money, it
issues a new bond and sells it in the marketplace
• Amount borrowed is equal to price of bond
– The higher the price, the lower the interest rate
• General principle applies to virtually all types of bonds
– When price of bonds rises, interest rate falls
• When price of bonds falls, interest rate rises
• Relationship between bond prices and interest rates helps
explain why government, press, and public are so
concerned about the bond market
– Where bonds issued in previous periods are bought and sold
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Back to the Money Market
• Complete sequence of events
Can also do the same analysis from the other direction
Would be an excess demand of money, and an excess supply of
bonds
In this case, the following would happen
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What Happens When Things
Change?
• Focus on two questions
– What causes equilibrium interest rate to
change?
– What are consequences of a change in the
interest rate?
• Fed can change interest rate as a matter of
policy, or
– Interest rate can change on its own
• As a by-product of other events
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How the Fed Changes the Interest
Rate
• Changes in interest rate from day-to-day, or week-to-week, are often
caused by Fed
– Fed officials cannot just declare that interest rate should be lower
• Fed must change the equilibrium interest rate in the money market
• Does this by changing money supply
– The process works like this
Fed can raise interest rate as well, through open market sales of bonds
Setting off the following sequence of events
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How the Fed Changes the Interest
Rate
• If Fed increases (decreases) money
supply by buying (selling) government
bonds, the interest rate falls (rises)
– By controlling money supply through
purchases and sales of bonds
• Fed can also control the interest rate
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Figure 6: An Increase in the Money
Supply
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How Do Interest Rate Changes
Affect the Economy?
• If Fed increases money supply through
open market purchases of bonds
– Interest rate will fall
• How is the macroeconomy affected?
– A drop in the interest rate will boost several
different types of spending in the economy
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How the Interest Rate Affects
Spending
• Lower interest rate stimulates business spending
on plant and equipment
– Remember that the interest rate is one of the key costs
of any investment project
• A firm deciding whether to spend on plant and
equipment compares benefits of project—increase
in future income—with costs of project
• Interest rate changes also affect spending on new
houses and apartments that are built by
developers or individuals
– Loan agreement for housing is called a mortgage
• Mortgage interest rates tend to rise and fall with other interest
rates
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How the Interest Rate Affects
Spending
• Interest rate affects consumption spending on big ticket
items
– Such as new cars, furniture, and dishwashers
– Economists call these consumer durables because they usually
last several years
• Can summarize impact of money supply changes as
follows
– When Fed increases money supply, interest rate falls, and
spending on three categories of goods increases
• Plant and equipment
• New housing
• Consumer durables (especially automobiles)
– When Fed decreases money supply, interest rate rises, and these
categories of spending fall
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Monetary Policy and the Economy
• Fed—through its control of money supply—has power to influence real
GDP
• When Fed controls or manipulates money supply in order to achieve any
macroeconomic goal it is engaging in monetary policy
• To find final equilibrium in economy, would need quite a bit of information
about how sensitive spending is to drop in the interest rate
– As well as how changes in income feed back into money market to affect
interest rate
– This is what happens when Fed conducts open market purchases of bonds
Open market sales by Fed have exactly the opposite effects
Equilibrium GDP would fall by a multiple of the initial decrease in spending
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Figure 7(a): Monetary Policy and
the Economy
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Figure 7(b): Monetary Policy and
the Economy
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An Increase in Government
Purchases
• What happens when government changes its fiscal policy
– Say, by increasing government purchases
• Increase in government purchases will set off multiplier
process
– Increasing GDP and income in each round
• Increase in government purchases, which by itself shifts
the aggregate expenditure line upward
– Also sets in motion forces that shift it downward
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An Increase in Government
Purchases
• At the same time as the increase in government purchases
has a positive multiplier effect on GDP
– Decrease in a and I have negative multiplier effects
• In short-run, increase in government purchases causes real
GDP to rise
– But not by as much as if interest rate had not increased
– Aggregate expenditure line is higher, but by less than ΔG
– Real GDP and real income are higher
• But rise is less than [1/(1 – MPC)] x ΔG
– Money demand curve has shifted rightward
• Because real income is higher
– Interest rate is higher
• Because money demand has increased
– Autonomous consumption and investment spending are lower
• Because the interest rate is higher
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Figure 8(a): Fiscal Policy and the
Money Market
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Figure 8(b): Fiscal Policy and the
Money Market
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Crowding Out Once Again
• When effects in money market are included in short-run
macro model
– An increase in government purchases raises interest rate and
crowds out some private investment spending
– May also crowd out consumption spending
• In classical, long-run model, an increase in government
purchases also causes crowding out
• In short-run, however, conclusion is somewhat different
– While we expect some crowding out from an increase in
government purchases, it is not complete
– Investment spending falls, and consumption spending may fall, but
together, they do not drop by as much as rise in government
purchases
– In short-run, real GDP rises
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Other Spending Changes
• Positive shocks would shift aggregate expenditure line
upward
• Increases in government purchases, investment, net
exports, and autonomous consumption, as well as
decreases in taxes, all shift aggregate expenditure line
upward
– Real GDP rises, but so does interest rate
– Rise in equilibrium GDP is smaller than if interest rate remained
constant
• Negative shocks shift aggregate expenditure line downward
• Decreases in government purchases, investment, net
exports, and autonomous consumption, as well as increases
in taxes, all shift aggregate expenditure line downward
– Real GDP falls, but so does interest rate
– Decline in equilibrium GDP is smaller than if interest rate remained
constant
35
What About the Fed?
• In our analysis of spending shocks, we’ve made
an implicit but important assumption
– Assumed Fed does not change money supply in
response to shifts in aggregate expenditure line
• While this assumption has helped us focus on the
impact of spending shocks
– It is not the way Fed has conducted policy during past
few decades
• Has used monetary policy to prevent spending shocks from
changing GDP at all
36
Are There Two Theories of the
Interest Rate?
• In classical model, interest rate is determined in market for loanable
funds
– In this chapter you learned that interest rate is determined in money
market
• Where people make decisions about holding their wealth as money and bonds
– Which theory is correct?
• Both
• Why don’t we use classical loanable funds model to determine the
interest rate in short-run?
– Because economy behaves differently in short-run than it does in long-run
• In long run, we view interest rate as determined in market for loanable
funds
– Where household saving is lent to businesses and government
• In short-run, we view interest rate as determined in the money market
– Where wealth holders adjust their wealth between money and bonds, and
Fed participates by controlling money supply
37
Expectations and the Money Market
• Important insight of money market analysis in this chapter
– Inverse relationship between a bond’s price and interest rate it
earns for its holder
– Therefore, if people expect interest rate to fall, they must be
expecting price of bonds to rise
– Will affect money market
• A general expectation that interest rates will rise (bond
prices will fall) in the future
– Will cause money demand curve to shift rightward in the present
• When public as a whole expects interest rate to rise (fall)
in the future, they will drive up (down) interest rate in the
present
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Figure 9: Interest Rate Expectations
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Using the Theory: The Fed and the
Recession of 2001
• Our most recent recession officially lasted from March to November of
2001
– What did policy makers do to try to prevent the recession, and to deal with
it once it started?
– Why did consumption spending behave abnormally, rising as income fell,
and preventing recession from becoming a more serious downtown?
• Starting in January 2001—three months before the official start of the
recession—Fed began to worry
– Investment spending had already decreased for two quarters in a row
• Fed decided to take action
– Beginning in January, Fed began increasing M1 rapidly
• Federal funds rate is interest rate banks with excess reserves charge for
lending reserves to other banks
• Federal funds rate fell continually and dramatically during the year, from 6.4%
down to 1.75%
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Using the Theory: The Fed and the
Recession of 2001
• While Fed’s policy was able to completely avoid the
recession
– It no doubt saved economy from a more severe and longer-lasting
one
• Fed’s policy also helps us understand the other question
we raised about the 2001 recession
– Continued rise in consumption spending throughout the period
– Lower interest rates stimulate consumption spending on consumer
durables
• Why wasn’t Fed able to prevent recession entirely?
– Couldn’t Fed have reduced interest rate even more rapidly?
• There are, in general, good reasons for Fed to be cautious in reducing
interest rates
• By historical standards, decrease in 2001 was quite dramatic
• Most economists—despite recession of 2001—give Fed
high marks for its actions during that year
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Figure 10:
The Fed in Action—2001
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