The Money Demand & Equilibrium Interest Rate

Outline:

1. The Demand for Money2. The Equilibrium Interest Rate3. Monetary Policy

The Money Demand & Equilibrium Interest Rate| The Demand for Money |

Why people demand for money??

Transaction Motive (Lt)- Money, as a medium of exchange is demanded in

order to carry out day to day transaction (daily expenditure)

Precautionary motive - Money demanded in case of unforeseen circumstances which my require

cash balances.

Speculative Motive (Ls)- One reason for holding bonds instead of money:

Investors may want to hold bonds when interest rates are high with the hope of

selling them when interest rates fall.

The Money Demand & Equilibrium Interest Rate| The Demand for Money |

Total Demand for Money:Lt = money demand for transaction motive + money demand for precautionary motive.Lt = f(Y) , and Lt ≠ f(r)Ls = money demand for speculative motive.Ls = f(r)Total demand for money (Md) = Lt + Ls

Ls : bonds price is inversely related to the interest rate. When the interest rates are high (bonds price are low) – public would find it attractive to hold bonds. When interest rates fall, the bonds will increase in price. Thus, when interest rates are low, it is a good time to be holding money and not bond.

Ltr

Money, M

Ls Md

r1

r0

Money, M Money, M

The Money Demand & Equilibrium Interest Rate| Demand for Money: The Demand Curve for Money Balances|

Money, M

r, % • The quantity of money demanded (the amount of money households and firms want to hold) is a function of the interest rate.

• The total quantity of money demanded in the economy is the sum of the demand for checking account balances and cash by both households and firms.

• For both households and firms, the quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate.

Md r

Md r

Increases (decreases) in the interest rate reduce (increase) the quantity of money that firms and households want to hold.

The Money Demand & Equilibrium Interest Rate| Demand for Money: The Effects of Y and Price Level on Md|

An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right

• An increase in Y means that there is more economic activity. Firms are producing and selling more, and households are earning more income and buying more.

• There are more transactions, for which money is needed.

• As a result, both firms and households are likely to increase their holdings of money balances at a given interest rate.

The Money Demand & Equilibrium Interest Rate| Demand for Money: The Determinants|

• The interest rate: r (The quantity of money demanded is a negative function of the interest rate.)

• The dollar volume of transactions

a. Aggregate output (income): Y (An increase in Y shifts the money demand curve to the right.)

b. The price level: P (An increase in P shifts the money demand curve to the right.)

The Money Demand & Equilibrium Interest Rate| The Equilibrium Interest Rate|

How is the interest rate determined in the economy?

Md = Ms

The Equilibrium Interest Rate:

The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.

The Money Demand & Equilibrium Interest Rate| The Equilibrium Interest Rate|

Equilibrium exists in the money market when the supply of money is equal to the demand for money and thus when the supply of bonds is equal to the demand for bonds.

At r0 the price of bonds would be bid up (and thus the interest rate down), and at r1 the price of bonds would be bid down (and thus the interest rate up).

Supply and Demand of Money Market

Adjustments in the Money Market

The Money Demand & Equilibrium Interest Rate| The Equilibrium Interest Rate|

The Effect of an Increase in the Supply of Money on the Interest Rate

An increase in the supply of money from Ms0 to Ms1 lowers the rate of interest from 7 percent to 4 percent.

Changing the Money Supply to Affect the Interest Rate

The Money Demand & Equilibrium Interest Rate| The Equilibrium Interest Rate|

Increases in Y and Shifts in the Money Demand Curve

An increase in aggregate output (income) shifts the money demand curve to the right from Mdo to Md1, which raises the equilibrium interest rate from 4 percent to 7 percent (e0 to e1).

An increase in price level, P also shifts the money demand curve to the right (from Mdo to Md1).

The Effect of an Increase in aggregate output (Income), Y or price level (P) on the Interest Rate

e0

e1

The Money Demand & Equilibrium Interest Rate| Federal Policies in Stabilizing Money Market|

Contractionary monetary policy: Fed policies that contract the money supply and thus raise interest rates in an effort to restrain the economy.

Expansioanary monetary policy: Fed policies that expand the money supply and thus lower interest rates in an effort to stimulate the economy.

Md

MS0MS1

r0

r1

MS1MS0

Md

r0

r1

Interest rate, r

Money, M

Money, M