Lecture 20 Flashcards
The opporuntiy cot of holing money
he Opportunity Cost of Holding
Money
* We all carry some cash around for
the convenience.
* When we do, we give up interest
income we’d collect if that spending
power were in an interest-bearing
asset like a bond.
* There is a price to be paid for the
convenience of holding money.
Ceritificate of deposit
is a bank-issued asset that allows customers to deposit their funds for a specified amount of time, and, in return, the bank pays a specified interest rate.
Short-term interest rates and long term and what happens ot oppporinutyi cost when intereet rates increase
Short-term interest rates: the interest rates on financial
assets that mature within six months
* Long-term interest rates: interest rates on financial
assets that mature a number of years in the future
* The higher the interest rate, the higher the opportunity
cost of holding money.
* The lower the interest rate, the lower the opportunity
cost of holding money.
.
short-term rates tend
short-term rates tend to move in the same direction
Money Demand Curve (What is the Y axis and X axis and
higher interest rate increases the opportunity cost of holding money, leading the public to reduce the quantity of money it demands.
Y-Axis : Interest rate, r
X Axis: QUantity of money
Shifts of the money demand curve:
An increase in the demand for money corresponds to a rightward shi of the MD curve, raising the quantity of money demanded at any given interest rate; a decrease in the demand for money corresponds to a le ward shi of the MD curve, reducing the quantity of money demanded at any given interest rate.
The most important factors causing the money demand curve to shi are changes in the aggregate price level, changes in real GDP, changes in credit markets and banking technology, and changes in institutions.
1) Changes in aggregate price level
- Higher prices means we eed more money for transacations (and vice versa)
2. Change in real GDP
- More goods and services produced and sold measn we need money
3. Changes in technology
- The ease of credit cards reduces the need for money, shifting the demand curve for money to the left
4. Change in insitiutions
- After 1980 banks were allowed to offer interest on checking accounts. This decreased the cost of holding money, and money demand increased. And it shifted the money demand curve to the right
how does the Fed and BoC control interest rates, and where does money supply go on the Money market graph (where Money demand is)
When is the market at equbirlium in the money market grpaghh, what if theyre not in eqbirulium how does the fed fix it
- We need to understand how interest rates are set in the maret:
- The liquidity preference model of the interest rate asserts that the interest rate is deteremined by the supply and demand for money
Money supply curve is vertical and deos not move regarless of interest rate. As the money supply is chosen by the federal reserve
- The money supply curve: shows how the nomila quantity of money supplied varies with the
The money market is in equbriulm when Money demanded = money supplied.
If they are not in eqbiruuilum , example includeing that a point in MD surpasses MS, and therefore the interest rate is lower than Re(equbirulum interest rate) the fed will drive interest rate up and vice versa
he Federal Reserve can increase or decrease the money supply: 3 ways
The Federal Reserve can increase or decrease the money supply:
it usually does this through open-market operations, buying or selling Treasury bills,
but it can also lend via the discount window
or change reserve requirements.
Explain what happens when the public wants to hold money larger than money supply and its two implications
To understand why rE is the equilibrium interest rate, consider what happens if the money market is at a point like L, where the interest rate, rL, is below rE. At rL the public wants to hold the quantity of money ML , an amount larger than the actual money supply,
This means that at point L, the public wants to shi some of its wealth out of interest-bearing assets such as CDs into money
This result has two implications.
1. The quantity of money demanded is more than the quantity of money supplied.
2. The quantity of interest-bearing nonmoney assets demanded is less than the quantity supplied
So those trying to sell nonmoney assets will find that they have to offer a higher interest rate to attract buyers. As a result, the interest rate will be driven up from rL until the public wants to hold the quantity of money that is actually available, That is, the interest rate will rise until it is equal to rE.
Now consider what happens if the money market is at a point such as H in Figure 19-3, where the interest rate rH is above rE. In that case, the quantity of money demanded, MH, is less than the quantity of money supplied, Correspondingly, the quantity of interest- bearing nonmoney assets demanded is greater than the quantity supplied. Those trying to sell interest-bearing nonmoney assets will find that they can offer a lower interest rate and still find willing buyers. This leads to a fall in the interest rate from rH. It falls until the public wants to hold the quantity of money that is actually available, Again, the interest rate will end up at rE.
What happns when the Fed inreases the money supply from M1 to M2.
n increase in the money supply by the Fed to shi s the money supply curve to the right,from MS1 to MS2, and leads to a fall in the equilibrium interest rate to r2. Why? Because r2 is the only interest rate at which the public is willing to hold the quantity of money actually supplied,
So an increase in the money supply drives the interest rate down. Conversely, a reduction in the money supply drives the interest rate up. By adjusting the money supply up or down, the Fed can set the interest rate.
The target federal funds rate is
The target federal funds rate is the Federal Reserve’s desired federal funds rate.
his is the rate at which commercial banks borrow and lend their excess reserves to
So wha happnes to oney supply grapgh when the fed purchases/sells treasuries
When the fed purchases treasurieiers, there is more quanttiy of money so M1->M2 and Interest rates fall as a result and vice versa
What happens in the long run to the money supply
In the long run the economy is self correcting and changes in the money supply doesnt affect price level but not the output or interest rate
So
ex:
Increase in money supply reduce the interest rate decreases and aggregate demand increases
THEN:
In the long run, nominal wages increase which decreases aggregare supply and puts M2 backt o potienal output and interest back to Re
What happens when money supply changes in the long run in th emoey market grapgh? interest rates and output i the longrun in the money market graph
In the long run,
he level of the money supply does not influence the amount of real output nor the interest rate
nterest rates and output i the longrun in the money market graph dont change
Monetary Neutrality and how does money supply change aggregate price level
changes in the money supply donʼt have any effect on real GDP, interest rates, or anything else except the price level, for the long run
Economists believe that money is neutral in the long run.
How much does a change in the money supply change the aggregate price level in the long run? The answer is that a change in the money supply leads to an equal proportional change in the aggregate price level in the long run. For example, if the money supply falls 25%, the aggregate price level falls 25% in the long run; if the money supply rises 50%, the aggregate price level rises 50% in the long run.
