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 rates—why 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 contingencies—accidents, lawsuits, e.g. • To store wealth—as 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: • Mdis 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. Mdis 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 0 500 700 800 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 $300 billion. • When r = 6%, Ms = Md 7% E 6% 3% Md 0 415 500 800 Money($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