The Money Market and the Interest Rate

1
The Money Market and the Interest Rate

• Outline
• Why agents wish to hold money.
• The portfolio choice
• The demand for money
• Bond prices and interest rateswhy they move
  inversely
• Bearishness and bullishness in the money market
• The supply of money
• Equilibrium in the money market
• How the money market reaches equilibrium.

2
Why do agents want to hold money?

• To make transactions
• To be prepared for contingenciesaccidents,
  lawsuits, e.g.
• To store wealthas an alternative to bonds,
  equities, jewelry, farmland, etc.

3
The Portfolio Decision Money or Bonds?

• Bonds yield interest money does not.
• The opportunity cost of holding money is given by
  the interest that could have been earned by
  holding bonds.

Interest is the reward for parting with
liquidity.
4
The Demand for Money (Md)

• Where
• Md is the total demand for money
• P is the price level
• Y is real income (or GDP)
• r is the rate of interest (or percentage yield of
  bonds).

5
Md is positively related to P and Y, ceteris
paribus. Also, Md is inversely related to r,
ceteris paribus.
6
Demand for Money
InterestRate

• As we move along Md, P and Y are held constant.
• The movement from point E to F is a change in the
  demand for money as a store of value in reaction
  to a decrease in the yield of bonds.

E
6
F
3
Md
0
500
800
Money(Billions)
7
Effect of a Change in Price Level (P) or Real GDP
(Y)
InterestRate

• Md1 ?Md2
• Increase in P, ceteris paribus.
• Increase in Y, ceteris paribus

G
E
6
H
F
3
Md2
Md1
0
500
800
700
1,000
Money(Billions)
8
Bond Prices and the Rate Of Interest
Bond prices and interest rates (or yields), move
inversely
9
Example
Suppose you paid 800 for a bond that
promises to pay 1,000 to its holder one year
from today. What is the interest rate or
percentage yield of the bond? Notice first that
your interest income would be equal to 200.
Hence to compute the yield, use the following
equation Yield () (interest income/price of
the bond) ? 100 Thus, we have Yield ()
(200/800) ? 100 25 percent Now suppose,
instead of paying 800 for the bond, you paid
900. What is the yield now? Yield ()
(100/900) ? 100 11 percent
10
Market Bullishness
To say the market is bullish is to say that, on
average, people forecast that interest rates will
decline hence bond prices are heading up.
11
Market Bearishness
When people are bearish, they expect interest
rates to rise, and bond prices to fall.
12
Bullishness means people want to hold less money
as a store of value.
Bullishness results in a decrease (shift to the
left) of the Md function as people buy bonds in
anticipation of rising prices.
13
Effects of Market Bearishness
InterestRate
E
K
6
F
3
Md2
Md1
0
500
800
Money(Billions)
14
The Supply of Money

• The supply of money schedule reveals the stock of
  money available to satisfy the demand for money
  at various interest rates.
• We assume the supply of money is determined by
  the Federal Reserve system or the Fed.
• The Fed can change the money supply by adjusting
  reserve requirements, the discount rate, or by
  open market operations.

15
Supply of Money (Ms)
InterestRate

• Ms1 ? Ms2
• Decrease of RRR
• Decrease of discount rate
• Open market purchase of government securities

Ms1
Ms2
6
E
J
3
0
500
700
Money(Billions)
16
Equilibrium in the Money market
InterestRate
Ms

• When r 7, Ms Md by 85 billion.
• When r 3, Md Ms by 300 billion.
• When r 6, Ms Md

7
E
6
3
Md
0
500
800
415
Money(Billions)
17
How does the money market reach equilibrium?
When there is an excess supply of money in the
economy, there is also an excess demand for bonds
Excess demandforbonds
Publicbuys bonds
Interest rate higher thanequilibrium
Excess supply ofmoney
Price of bonds rises