Download interest rate

28
Pump Primer:
• What do you believe is the
opportunity cost of holding
money?
Module 28
The Money
Market
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson
Biblical Integration
• To be a good steward of God's money
takes us back to the parable of the
talents (Matt. 25: 14-28) This parable
stresses how we as Christians have
been given a special gift and what we do
with it is more important than any earthly
riches.
What you will learn
in this Module:
• What the money demand curve is
• Why the liquidity preference model
determines the interest rate in the short
run
The Demand for Money
What would cause you to have more money in
your pocket today than you had yesterday?
What else can you do with your money.
• You can save it!
And what would make you interested in saving it?
• A higher interest rate.)
The Opportunity Cost of Holding
Money
It is convenient to hold money in your
pocket because it allows you to
conveniently make purchases.
The price of that convenience is that
money in your pocket earns no interest.
The Opportunity Cost of Holding
Money
Suppose you could put $100 in a 12month CD that would earn 5%. A CD is
not very liquid because if you withdraw
the money before 12 months, you forfeit
up to three months of interest.
$100 in your pocket or in your checking
account (M1) will come at an opportunity
cost of 5% or $5.
The Opportunity Cost of Holding
Money
Maybe it is easy to pass up $5 to have
the convenience of $100 in your pocket.
What if the interest rate was 50%? Would
you still hold $100 in your pocket when
the cost is now $50?
If the interest rate was 0.5%, how likely is
it that you would put the $100 in a CD?
Not very.
.
The Opportunity Cost of Holding
Money
Intuitively, this reflects a general result: 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.
Why don’t we consider long-term interest rates
like 10-year CD’s as the opportunity cost of
holding money? Because we hold money to
make transactions in the short term.
Therefore we must consider the opportunity
cost in the short term, not the long term.
The Money Demand Curve
Since we demand money to
make purchases in the short
term, the opportunity cost of
holding money is the short-term
interest rate.
We assume that in a short
period of time, there will be
virtually no inflation, so the
nominal interest rate is equal to
the real interest rate.
The Money Demand Curve
It is this assumption that allows
us to put the nominal interest
rate on the vertical axis of
graph of the money market.
You may lose points on the AP
exam if you label this axis as the
real interest rate.
The Money Demand Curve
As discussed above, when
the interest rate rises, the
opportunity cost of holding
money rises, so the
quantity of money
demanded will fall.
The Money Demand Curve
The money demand curve
is downward sloping.
An increase in the
nominal interest rate will
cause a movement
upward along the money
demand curve.
Shifts of the Money Demand
Curve
Just like there are external
factors that shift the demand
curve for pomegranates,
there are external factors that
shift the demand curve for
money.
if an external change makes
holding money in your pocket
more desirable at any interest
rate, the demand curve for
money will shift rightward.)
Shifts of the Money Demand
Curve
The most important factors
causing the money demand
curve to shift are changes in
the aggregate price level,
changes in real GDP,
changes in banking
technology, and changes in
banking institutions.
Shifts of the Money Demand
Curve
1. Changes in the
Aggregate Price Level
All else equal, higher prices
increase the demand for
money (a rightward shift of
the MD curve), and lower
prices reduce the demand for
money (a leftward shift of the
MD curve).
Shifts of the Money Demand
Curve
We can actually be more specific than this:
other things equal, the demand for money is
proportional to the price level. That is, if the
aggregate price level rises by 20%, the
quantity of money demanded at any given
interest rate, also rises by 20%.
Why? Because if the price of everything rises
by 20%, it takes 20% more money to buy the
same basket of goods and services.
Shifts of the Money Demand
Curve
2. Changes in Real GDP
As the economy gets stronger, real incomes
and real GDP rise.
The larger the quantity of goods and services
we buy, the larger the quantity of money we
will want to hold at any given interest rate.
Shifts of the Money Demand
Curve
So an increase in real
GDP—the total quantity of
goods and services produced
and sold in the economy—
shifts the money demand
curve rightward.
Shifts of the Money Demand
Curve
3. Changes in Technology
Changes in technology can affect the demand for
money. In general, advances in information
technology have tended to reduce the demand for
money by making it easier for the public to make
purchases without holding significant sums of
money.
If there was an ATM machine on every corner and
in every retail store and restaurant, there would be
little need to hold money in your pocket.
Shifts of the Money Demand
Curve
4. Changes in Institutions
Regulations that make it more attractive to
keep money in banks will reduce the demand
for money.
If a nation’s political and banking systems
became dangerously unstable, it might
increase the demand for money because
people would rather hoard their money than
store it in institutions that might be falling
apart.
Money and Interest Rates
The Fed uses the three tools of monetary
policy to achieve a target level for the federal
funds rate.
Since most interest rates will move closely
with the FFR, we can use the money market
to show how these policies work.
The Equilibrium Interest Rate
We assume that the money
supply MS is determined by
the Fed and is fixed at any
given point in time. It is also
independent of the interest
rate so it is depicted as a
vertical line.
The Equilibrium Interest Rate
Example What would happen to interest rates
and the quantity of money demanded if there
was some interest rate i1 that was greater than
i*?
If i1 > i*, the quantity of money supplied exceeds
the quantity of money demanded. Why?
Because of high interest rates, CDs are very
attractive saving options!
Rates fall, the quantity of money demanded
gets closer and closer to M*.
The Equilibrium Interest Rate
In fact, banks find that they can lower the
interest rate on CDs and still have plenty of
customers ready to buy a CD. As interest rates
fall, the quantity of money demanded gets
closer and closer to M*.
The Equilibrium Interest Rate
Example What would happen to interest rates
and the quantity of money demanded if there
was some interest rate i2 that was less than i*?
If i2 < i*, the quantity of money demanded
exceeds the quantity of money supplied. Why?
Because of low interest rates, CDs are not
very attractive saving options!
The Equilibrium Interest Rate
In fact, banks find that they must raise the
interest rate on CDs to get more customers
ready to buy a CD. As interest rates rise, the
quantity of money demanded gets closer and
closer to M*.
Two Models of the Interest Rate
The model of liquidity
preference describes
equilibrium in the money
market.
This model is a good
foundation for learning a
similar market in loanable
funds that is also useful in
describing how interest rates
are determined and the
impact of monetary policy
and other more advanced
topics