The Money Market and The Interest Rate

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• Chapter 12
• The Money Market and The Interest Rate

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The Demand For Money

• Demand for money does not mean how much money
  people would like to have in best of all worlds
• Rather, it means how much money people would like
  to hold, given constraints they face

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An Individuals Demand for Money

• At any given moment, total amount of wealth we
  have is given
• If we want to hold more wealth in form of money,
  we must hold less wealth in other forms
• Why hold wealth in form of money?
• Money is a means of payments
• Other forms of wealth provide a financial return
  to their owners
• Money pays either very little interest or none at
  all
• When you hold money, you bear an opportunity cost
• Interest you could have earned

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An Individuals Demand for Money

• Division of wealth between assets
• Money, which can be used as a means of payment
  but earns no interest
• Bonds, which earn interest, but cannot be used as
  a means of payment
• What determines how much money an individual will
  decide to hold?
• Price level
• Real income
• Interest rate
• When we add up everybodys behavior, we find a
  noticeable and stable tendency for people to hold
  less money when it is more expensive to hold
  money
• When the interest rate is higher

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The Economy-Wide Demand For Money

• Demand for money depends on the same three
  variables that we discussed for individuals
• A rise in the price level increased demand for
  money
• A rise in real income (real GDP) increased
  demand for money
• A rise in interest rate decreased demand for
  money

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Figure 1 The Money Demand Curve
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Shifts in the Money Demand Curve

• What happens when something other than interest
  rate changes quantity of money demanded?
• Curve shifts
• A change in interest rate moves us along money
  demand curve

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Figure 2 A Shift in the Money Demand Curve
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Figure 3 Shifts and Movements Along the Money
Demand CurveA Summary
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The Supply of Money

• Suppose Fed, for whatever reason, were to change
  money supply
• Would be a new vertical line
• Showing a different quantity of money supplied at
  each interest rate
• Open market purchases of bonds inject reserves
  into banking system
• Shift money supply curve rightward by a multiple
  of reserve injection
• Open market sales have the opposite effect
• Withdraw reserves from system
• Shift money supply curve leftward by a multiple
  of reserve withdrawal

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Figure 4 The Supply of Money
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Equilibrium in the Money Market

• Money demand curve tells us how much money people
  want to hold at each interest rate
• Equilibrium in money market occurs when quantity
  of money people are actually holding (quantity
  supplied) is equal to quantity of money they want
  to hold (quantity demanded)

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Figure 5 Money Market Equilibrium
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How the Money Market Reaches Equilibrium

• If people want to hold less money than they are
  currently holding, then, by definition
• They must want to hold more in bonds than they
  are currently holding
• An excess demand for bonds
• When there is an excess supply of money in
  economy
• There is also an excess demand for bonds
• Can illustrate steps in our analysis so far as
  follows

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Bond Prices and Interest Rates

• A bond, in the simplest terms, is a promise to
  pay back borrowed funds at a certain date or
  dates in the future
• When a large corporation or government wants to
  borrow money, it issues a new bond and sells it
  in the marketplace
• Amount borrowed is equal to price of bond
• The higher the price, the lower the interest rate
• General principle applies to virtually all types
  of bonds
• When price of bonds rises, interest rate falls
• When price of bonds falls, interest rate rises
• Relationship between bond prices and interest
  rates helps explain why government, press, and
  public are so concerned about the bond market
• Where bonds issued in previous periods are bought
  and sold

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Back to the Money Market

• Complete sequence of events

• Can also do the same analysis from the other
  direction
• Would be an excess demand of money, and an excess
  supply of bonds
• In this case, the following would happen

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What Happens When Things Change?

• Focus on two questions
• What causes equilibrium interest rate to change?
• What are consequences of a change in the interest
  rate?
• Fed can change interest rate as a matter of
  policy, or
• Interest rate can change on its own
• As a by-product of other events

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How the Fed Changes the Interest Rate

• Changes in interest rate from day-to-day, or
  week-to-week, are often caused by Fed
• Fed officials cannot just declare that interest
  rate should be lower
• Fed must change the equilibrium interest rate in
  the money market
• Does this by changing money supply
• The process works like this

• Fed can raise interest rate as well, through open
  market sales of bonds
• Setting off the following sequence of events

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How the Fed Changes the Interest Rate

• If Fed increases (decreases) money supply by
  buying (selling) government bonds, the interest
  rate falls (rises)
• By controlling money supply through purchases and
  sales of bonds
• Fed can also control the interest rate

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Figure 6 An Increase in the Money Supply
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How Do Interest Rate Changes Affect the Economy?

• If Fed increases money supply through open market
  purchases of bonds
• Interest rate will fall
• How is the macroeconomy affected?
• A drop in the interest rate will boost several
  different types of spending in the economy

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How the Interest Rate Affects Spending

• Lower interest rate stimulates business spending
  on plant and equipment
• A firm deciding whether to spend on plant and
  equipment compares benefits of projectincrease
  in future incomewith costs of project
• Interest rate changes also affect spending on new
  houses and apartments that are built by
  developers or individuals

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How the Interest Rate Affects Spending

• Interest rate affects consumption spending on big
  ticket items
• Such as new cars, furniture, and dishwashers
• Economists call these consumer durables because
  they usually last several years
• Can summarize impact of money supply changes as
  follows
• When Fed increases money supply, interest rate
  falls, and spending on three categories of goods
  increases
• Plant and equipment
• New housing
• Consumer durables (especially automobiles)
• When Fed decreases money supply, interest rate
  rises, and these categories of spending fall

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Monetary Policy and the Economy

• Fedthrough its control of money supplyhas power
  to influence real GDP
• When Fed controls or manipulates money supply in
  order to achieve any macroeconomic goal it is
  engaging in monetary policy
• To find final equilibrium in economy, would need
  quite a bit of information about how sensitive
  spending is to drop in the interest rate
• As well as how changes in income feed back into
  money market to affect interest rate
• This is what happens when Fed conducts open
  market purchases of bonds

• Open market sales by Fed have exactly the
  opposite effects
• Equilibrium GDP would fall by a multiple of the
  initial decrease in spending

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Figure 7(a) Monetary Policy andthe Economy
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Figure 7(b) Monetary Policy andthe Economy
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An Increase in Government Purchases

• What happens when government changes its fiscal
  policy
• Say, by increasing government purchases
• Increase in government purchases will set off
  multiplier process
• Increasing GDP and income in each round
• Increase in government purchases, which by itself
  shifts the aggregate expenditure line upward
• Also sets in motion forces that shift it downward

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An Increase in Government Purchases

• At the same time as the increase in government
  purchases has a positive multiplier effect on GDP
• Decrease in a and I have negative multiplier
  effects
• In short-run, increase in government purchases
  causes real GDP to rise
• But not by as much as if interest rate had not
  increased
• Aggregate expenditure line is higher, but by less
  than ?G
• Real GDP and real income are higher
• But rise is less than 1/(1 MPC) x ?G
• Money demand curve has shifted rightward
• Because real income is higher
• Interest rate is higher
• Because money demand has increased
• Autonomous consumption and investment spending
  are lower
• Because the interest rate is higher

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Figure 8(a) Fiscal Policy and theMoney Market
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Figure 8(b) Fiscal Policy and theMoney Market
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Crowding Out Once Again

• When effects in money market are included in
  short-run macro model
• An increase in government purchases raises
  interest rate and crowds out some private
  investment spending
• May also crowd out consumption spending
• In classical, long-run model, an increase in
  government purchases also causes crowding out
• In short-run, however, conclusion is somewhat
  different
• While we expect some crowding out from an
  increase in government purchases, it is not
  complete
• Investment spending falls, and consumption
  spending may fall, but together, they do not drop
  by as much as rise in government purchases
• In short-run, real GDP rises

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Other Spending Changes

• Positive shocks would shift aggregate expenditure
  line upward
• Increases in government purchases, investment,
  net exports, and autonomous consumption, as well
  as decreases in taxes, all shift aggregate
  expenditure line upward
• Real GDP rises, but so does interest rate
• Rise in equilibrium GDP is smaller than if
  interest rate remained constant
• Negative shocks shift aggregate expenditure line
  downward
• Decreases in government purchases, investment,
  net exports, and autonomous consumption, as well
  as increases in taxes, all shift aggregate
  expenditure line downward
• Real GDP falls, but so does interest rate
• Decline in equilibrium GDP is smaller than if
  interest rate remained constant

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Expectations and the Money Market

• A general expectation that interest rates will
  rise (bond prices will fall) in the future
• Will cause money demand curve to shift rightward
  in the present
• When public as a whole expects interest rate to
  rise (fall) in the future, they will drive up
  (down) interest rate in the present

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Figure 9 Interest Rate Expectations
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Using the Theory The Fed and the Recession of
2001

• Our most recent recession officially lasted from
  March to November of 2001
• What did policy makers do to try to prevent the
  recession, and to deal with it once it started?
• Why did consumption spending behave abnormally,
  rising as income fell, and preventing recession
  from becoming a more serious downtown?
• Starting in January 2001three months before the
  official start of the recessionFed began to
  worry
• Investment spending had already decreased for two
  quarters in a row
• Fed decided to take action
• Beginning in January, Fed began increasing M1
  rapidly
• Federal funds rate is interest rate banks with
  excess reserves charge for lending reserves to
  other banks
• Federal funds rate fell continually and
  dramatically during the year, from 6.4 down to
  1.75

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Using the Theory The Fed and the Recession of
2001

• While Feds policy was able to completely avoid
  the recession
• It no doubt saved economy from a more severe and
  longer-lasting one
• Feds policy also helps us understand the other
  question we raised about the 2001 recession
• Continued rise in consumption spending throughout
  the period
• Lower interest rates stimulate consumption
  spending on consumer durables
• Why wasnt Fed able to prevent recession
  entirely?
• There are, in general, good reasons for Fed to be
  cautious in reducing interest rates
• By historical standards, decrease in 2001 was
  quite dramatic
• Most economistsdespite recession of 2001give
  Fed high marks for its actions during that year