Download a) If money supply = $150, what is the equilibrium interest rate?

LO1
Supply of Money
Interest Rate
• the annual rate at which payment is made for the
use of money (or borrowed funds)
• a percentage of the borrowed amount
• the price of money
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9- 1
LO1
Supply of Money
Rate of interest
The supply of money is determined
by the Bank of Canada
MS
the supply of money
is constant at any
one point in time
Quantity of money
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LO1
The Bank of Canada
• Canada’s central bank
• Government owned institution
• Directors and governor are appointed by the
federal cabinet
• Current governor Mark Carney
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LO1
Functions of the Bank of Canada
• The issuer of currency
• The government’s bank and manager of foreign
currency reserves
• The bankers’ bank and lender of last resort
• The auditor and inspector of commercial banks
• The regulator of the money supply
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LO1
Demand for Money
Made up of 2 types of demand:
1. Transactions demand for money
– The desire to hold money as a medium of exchange,
that is, to effect transactions
– The major determinants are the level of real income
and the level of prices
2. Asset demand for money
– The desire to use money as a store of wealth, that is,
to hold money as an asset
– The major determinant is the rate of interest
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LO1
Transactions Demand
MDT
r
Transactions demand
is unrelated to the
rate of interest
r1
r2
Q
Quantity of Money
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9- 6
LO1
Asset Demand
r
There is an inverse
relationship between
asset demand and the
rate of interest
r1
r2
MDA
Q1
Q2
Q of Money
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LO1
Money Demand
MDT
r
Total demand for
money is the sum of
transactions demand
+ asset demand
MDA
MD= MDT+ MDA
Q of Money
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9- 8
LO1
Demand for Money
Determined by:
1. The level of transactions (real GDP)
2. The average value of transactions (the price
level)
3. The rate of interest
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LO1
Equilibrium
Surplus
MS
r3
r1
• At equilibrium interest rate,
r1, there is no surplus or
shortage of money.
• At any other rate there is
either a shortage or surplus.
r2
Shortage
Q1
MD
Q of M
© 2012 McGraw-Hill Ryerson Limited
9- 10
Self-Test 1
LO1
a) Assume that the nominal GDP in this economy is $800 and
that the transaction demand for money is equal to 10 percent
of nominal GDP. Draw in the total demand for money curve.
b) If the money supply is $150 billion, draw in the money supply
curve.
c) If the interest rate, is 10 percent, is there a surplus or
shortage of money? How much?
© 2012 McGraw-Hill Ryerson Limited
9-11
Self-Test 1
LO1
a) Assume that the nominal GDP in this economy is $800 and
that the transaction demand for money is equal to 10 percent
of nominal GDP. Draw in the total demand for money curve.
Interest rate
12
11
Asset Demand
($billions)
50
55
10
9
8
60
65
70
7
6
75
80
Transaction
Demand
© 2012 McGraw-Hill Ryerson Limited
MD
9-12
Self-Test 1
LO1
a) Assume that the nominal GDP in this economy is $800 and
that the transaction demand for money is equal to 10 percent
of nominal GDP. Draw in the total demand for money curve.
b) If the money supply is $150 billion, draw in the money supply
curve.
S
i
12%
10%
6%
D
140
150 160
© 2012 McGraw-Hill Ryerson Limited
Q
9-13
Self-Test 1
LO1
c) If the interest rate is 10 percent, is there a surplus or shortage
of money? How much?
S
i
12%
10%
6%
D
140
150 160
© 2012 McGraw-Hill Ryerson Limited
Q
9-14
LO1
How the Money Market Adjusts
– Money markets adjust to a surplus or shortage
through bond yields
– People can hold wealth as either money or bonds
– Surplus of money: people buy bonds
– Shortage of money: people sell bonds
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9- 15
LO1
Bond Yields
Bonds
– Loans for a set period of time
– Issued by corporations, banks, and various levels
of government
– Have a set face value
– Pay a fixed rate of interest (the coupon rate)
– Can be bought and sold in the market
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LO1
Bond Yields
Bonds:
- The return (“yield”) on a bond depends on:
1. the coupon rate
2. the profit or loss on its sale
Rate of return (rate of interest) =
coupon interest +/  change in the bond price
 100
Price paid for bond
- Bond prices adjust to reflect return on other
financial instruments with similar risk
- The higher the price, the lower the return
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LO1
Bond Yields
Rate of return (rate of interest) =
coupon interest +/  change in the bond price
 100
Price paid for bond
Example: $5000 bond, 4% coupon rate, 1 year
($200  $300)
 100  10.64%
4700
($200  $100)
$4900: Rate of return =
 100  6.12%
4900
($200  $100)
$5100: Rate of return =
 100  1.96%
5100
Purchase price: $4700: Rate of return =
- The higher the price, the lower the yield
- The lower the price, the higher the yield
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LO1
How the Money Market Adjusts
Surplus of money
– People choose to buy bonds to reduce their
liquidity and earn income
– Bond prices rise, leading to a fall in bond yields
and interest rates
– Rates fall until there is no more surplus
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9- 19
LO1
How the Money Market Adjusts
Shortage of money
– People sell bonds in order to increase their
liquidity
– Bond prices fall, leading to an increase in bond
yields and interest rates
– Rates increase until there is no more shortage
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9- 20
LO1
How the Money Market Adjusts
Increase in interest rate caused by:
– Rise in the demand for money OR
– Fall in the supply of money
Decrease in interest rate caused by:
– Fall in the demand for money OR
– Rise in the supply of money
© 2012 McGraw-Hill Ryerson Limited
9- 21
Self-Test 2
LO1
a) If money supply = $150, what is the equilibrium interest rate?
b) If money supply = $140, what is the equilibrium interest rate?
c) If interest is 11% and MS = $150, what are the implications?
Interest rate
Asset Demand
($billions)
Transaction
Demand
MD
12
50
80
130
11
55
80
135
10
60
80
140
9
65
80
145
8
70
80
150
7
75
80
155
6
80
80
160
© 2012 McGraw-Hill Ryerson Limited
9-22
Self-Test 2
LO1
a) If money supply = $150, what is the equilibrium interest rate?
b) If money supply = $140, what is the equilibrium interest rate?
Interest rate
Asset Demand
($billions)
Transaction
Demand
MD
12
50
80
130
11
55
80
135
10
60
80
140
9
65
80
145
8
70
80
150
7
75
80
155
6
80
80
160
© 2012 McGraw-Hill Ryerson Limited
9-23
Self-Test 2
LO1
c) If interest is 11% and MS = $150, what are the implications?
Interest rate
Asset Demand
($billions)
Transaction
Demand
MD
12
50
80
130
11
55
80
135
10
60
80
140
9
65
80
145
8
70
80
150
7
75
80
155
6
80
80
160
© 2012 McGraw-Hill Ryerson Limited
9-24
Self-Test 4
LO1
Show the effects if the Bank of Canada buys $2 billion worth
of securities directly from the commercial banks.
All Commercial Banks
Bank of Canada
ASSETS
ASSETS
Reserves:
in vaults
$ 70
on deposit at B of C
T-bills and bonds
12
Securities
118
Loans
600
Total assets $ 800
Total assets $ 82
LIABILITIES
Notes in circulation
Deposits of banks
LIABILITIES
Deposits
$ 82
800
Other liabilities
Total liabilities $ 800
© 2012 McGraw-Hill Ryerson Limited
$ 65
12
5
Total liabilities $ 82
9-25
Self-Test 10
LO1
a) If M is $100, P is $2, and Q is 500, what is the velocity of
money?
b) Given the same parameters as in a), if the velocity of money
stays constant and assuming the economy is at full
employment, what will be the level of P if M increases to
$120?
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9-26