Example: A = P(1 + rt) Principal (P) = $10,000 Rate (R) = 20% Time = 5 years Total = $20,000

Transcription

1 The Money Market (Supply and Demand for Money)

2 The Demand for Money The Demand for money shows an inverse relationship between nominal interest rates and the quantity of money demanded Ø What happens to the quantity demanded of money when interest rates increase? IR ; Qd because it is expensive to borrow money. Ø What happens to the quantity demanded when interest rates decrease? IR ; Qd because it is very cheap to borrow money. Example: A = P(1 + rt) Principal (P) = $10,000 Rate (R) = 20% Time = 5 years Total = $20,000 A = P(1 + rt) Principal (P) = $10,000 Rate (R) = 2% Time = 5 years Total = $11,000

3 Money Market Graph (Demand) Inverse relationship between interest rates and the quantity of money demanded Nominal Interest Rate (Nir) 10% 5% 2% 0 D Money Quantity of Money (billions of dollars)

4 Money Market Graph (Demand) Nominal Interest Rate (Nir) 10% 5% AD : PL? Money Demand Shifters Ø Changes in price level Ø Changes in income Ø Changes in taxation that affects investment 2% D Money1 0 D Money Quantity of Money (billions of dollars)

5 The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED) Nominal Interest Rate (Nir) 10% 5% Money Market Graph (Supply) S Money The FED is a nonpartisan government office that sets the money supply to adjust the economy This is Monetary Policy. 2% D Money 200 Quantity of Money (billions of dollars)

6 Monetary Policy When the FED adjusts the money supply to achieve the macroeconomic goals

7 Nominal Interest Rate (Nir) 10% 5% 2% Money Market Graph ( Supply) S M S M1 If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. The surplus will cause the interest rate to fall to 2% How does this affect AD? Increase money supply D M Decreases interest rate Quantity of Money (billions of dollars) Increases investment Increases AD

8 Nominal Interest Rate (Nir) 10% 5% 2% Money Market Graph ( Supply) S M1 S M If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The shortage will cause the interest rate to rise to 10% How does this affect AD? 150 Decrease money supply 200 D M Increase interest rate Quantity of Money (billions of dollars) Decrease investment Decrease AD

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10 Video: The FED Today 10

11 2010 FRQ 2. A drop in credit card fees causes people to use credit cards more often for transactions and demand less money. (a) Using a correctly labeled graph of the money market, show how the nominal interest rate will be affected. (b) Given the interest rate change in part (a), what will happen to bond prices in the short run? (c) Given the interest rate change in part (a), what will happen to the price level in the short run? Explain. 11

12 2007 FRQ 1. Assume that Australia and New Zealand are trading partners. Australia s economy is currently in recession. (a) Now assume that Australia begins to recover from its recession. Using a correctly labeled graph of aggregate demand and aggregate supply for New Zealand, show the impact of Australia s rising income on each of the following in the short run. (i) Aggregate demand in New Zealand. Explain. (ii) Output in New Zealand (b) Using a correctly labeled graph of the money market for New Zealand, show the effect of the output change in part (a)(ii) on the following. (i) Demand for money. Explain. (ii) The nominal interest rate (c) Assume that the price level in New Zealand rises. Given your answer to part (b)(ii), explain what will happen to real interest rates. (d) Although recovering, Australia remains in recession and its government takes no action. Indicate whether each of the following curves will shift to the left, shift to the right, or remain unchanged in the long run in Australia. (i) Aggregate supply (ii) Aggregate demand 12

13 2007B Practice FRQ 13

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15 2007B Practice FRQ 15