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Lecture notes
Prepared by Anton Ljutic
CHAPTER EIGHT
The Money Market
© 2004 McGraw–Hill Ryerson Limited
This Chapter Will Enable
You to:
• Recognize that demand for money is not the same
as desire for income
• Distinguish two types of money demand
• Explain the downward sloping money demand
curve
• Explain and illustrate graphically how the money
supply and demand affect the equilibrium interest
rate
• Describe two views of how the money market
affects the level of real GDP and inflation
© 2004 McGraw–Hill Ryerson Limited
The Supply of Money
Rate of interest
• The supply of money is determined by the
Bank of Canada, which, can and and does
change the money supply as it sees fit
MS
Figure 8.1
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Quantity of money
The Demand for Money
• Transactions demand for money
– The desire of people 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
• Asset demand for money
– The desire by people to use money as a store of wealth,
that is, to hold money as an asset
– The major determinant is the rate of interest
© 2004 McGraw–Hill Ryerson Limited
Transactions Demand
MDT
r
The transactions demand for
money is unrelated to the rate
of interest
r1
r2
Figure 8.2A
Q
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Q of M
Asset Demand
r
There is an inverse
relationship between
the asset demand for
money and the interest
rate
r1
r2
MDA
Figure 8.2B
Q1
Q2
Q of M
© 2004 McGraw–Hill Ryerson Limited
Total Money Demand
r
MDT
It is the addition of the transactions
and asset demand
MDA
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MD= MDT+ MDA
Q of M
The Demand for Money is Determined by:
• The level of transactions (real GDP)
• The average value of transactions ( the price
level)
• The rate of interest
– The annual rate at which payment is made for
the use of money (borrowed funds); a
percentage of the borrowed amount
© 2004 McGraw–Hill Ryerson Limited
Equilibrium in the Money Market
Surplus
r3
•At equilibrium interest
rate, r1, there is
no surplus or shortage
of money.
•At any other rate there
is either a shortage
(e.g., r2) or a surplus
(e.g., r3).
MS
r1
r2
Shortage
Q1
MD
Q of M
© 2004 McGraw–Hill Ryerson Limited
Figure 8.3
A Shift in the Supply of Money
MS1
Surplus
r1
r2
Q1
Figure 8.4
•An increase in the
supply of money from
MS1 to MS2 will
initially cause a surplus
of money at the
prevailing interest rate
r1.
•People will want to
MD
dispose of the surplus
by buying bonds. This
will cause bond prices
to rise and interest rate
Q of M to fall to r2.
MS2
Q2
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An Increase in the Demand for Money
MS1
r2
r1
Shortage
MD2
MD1
Q of M
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•Total demand for money
will change if nominal
GDP changes.
•A higher price level or a
higher GDP will shift the
demand for money curve
to the right.
•This will initially cause a
shortage of money,
causing people to sell
some of their bonds and
causing bond prices to fall
and interest rates to rise
from r1 to r2
Money Market’s Effect on the Economy
• The money market and the product market are
intrinsically linked
• The transmission process illustrates that the
interest rate is the link between the two markets
– Transmission process
• The Keynesian view of how changes in money affect (transmit
to) the real variables in the economy
• Investment demand
– Investment is the most affected by changes in the
interest rate and the relationship is inverse
© 2004 McGraw–Hill Ryerson Limited
A Change in the Price Level (I)
AS1
AS2
An increase
in AS leads
to a decrease
in P
AS P
P1
P2
AD
Y1 Y2
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A Change in the Price Level (II)
A decrease in P
leads to a decease
in MD which leads
to a decrease in r
r1
P
r2
MD1
MD2
Y
© 2004 McGraw–Hill Ryerson Limited
MD
r
A Change in the Price Level (III)
A decrease in
r leads to an
increase in I
r
r1
r2
ID
I1
I2
© 2004 McGraw–Hill Ryerson Limited
I
A Change in the Price Level (IV)
AS1
An increase
in I leads
to an increase
in Y
AS2
P1
Summing up:
P2
AS up
AD
=> P down
P down => r down
r down => I up
Y1 Y2
© 2004 McGraw–Hill Ryerson Limited
I up
=> Y up
Effect of an Increase in Money Supply (I)
1
An increase in the money supply leads to a
decrease in the rate of interest
2
Lower rate of interest leads to an increase in
investment
3
Since P has not changed, an increase in
investment results in a shift in AD to AD2
© 2004 McGraw–Hill Ryerson Limited
Effect of an Increase in Money Supply (II)
MS1
MS2
r1
r1
r2
r2
ID
MD
Q1
Q2
I1
P1
AD2
AD1
© 2004 McGraw–Hill Ryerson Limited
Y1 Y2
I2
The Monetarist View
• Monetarism
– An economic school of thought that believes
that cyclical fluctuations of GDP and inflation
are usually caused by changes in the money
supply
– GDP determination can be summarized by the
equation of exchange
© 2004 McGraw–Hill Ryerson Limited
Equation Of Exchange (I)
• It is a formula that states that the quantity of
money (M) times the velocity of money (V) is
equal to nominal GDP (price (P) times real GDP
(Q)).
MV=PQ
– Velocity of money ( or velocity of circulation)
• The number of times per year that the average unit of currency
is spent (or turns over) buying goods and services
• The Monetarists believe that V is constant
• If we assume full employment and V is constant,
any increase in M will have a direct and
proportional impact on the price level
© 2004 McGraw–Hill Ryerson Limited
Equation Of Exchange (II)
1
MV = PQ
2
Nominal GDP = M x V
3
Nominal GDP = P x Q
© 2004 McGraw–Hill Ryerson Limited
Chapter Summary:
What to Study and Remember
• Demand for money is not the same as desire for
income
• There are two types of money demand
• The demand for money curve is downward
sloping money
• Could you explain and illustrate graphically how
the money supply and demand affect the
equilibrium interest rate?
• Describe two views of how the money market
affects the level of real GDP and inflation
© 2004 McGraw–Hill Ryerson Limited