ECON212: Elements of Economics II Univ. Of Ghana, Legon EQUILIBRIUM IN THE MONEY MARKET Lecture 7 Dr. Priscilla T. Baffour

ECON212: Elements of Economics II Univ. Of Ghana, Legon EQUILIBRIUM IN THE MONEY MARKET Lecture 7 Dr. Priscilla T. Baffour

Sections 1. Money Demand Motives 2. The Supply and Demand for Money 3. Monetary Forces and Aggregate Demand

Learning Outcomes There is an important distinction between money values and real (or relative) values. The market price of bonds is inversely related to the interest rate. Monetary equilibrium occurs where people are willing to hold the existing stock of money and bonds at the current interest rate. A rise in interest rates reduces aggregate demand, and vice versa.

Learning Outcomes Monetary and fiscal policies may assist the stabilization of the economy and control inflation, but inappropriate policies can make things worse. Central banks have the power to set interest rates because they are the monopoly supplier of high-powered money (notes and coins + deposits at the central bank).

Money Demand Motives Transactionary Demand for Money People and firms hold money because they have some recurrent transactions to pay for: School fees, salaries of employees, raw material costs, rent, transport fares, loans, phone recharge cards. Transactionary demand for money is determined mainly by the level of expenditure/income: The higher your income, the higher your transactionary balance. Thus, Tdmm is mainly determined by income: Tdmm=f(Y).

Precautionary Demand for Money This is the amount of money kept aside to meet unforeseen contingencies: unplanned visits, sickness etc. It is also a positive function of income: Pdmm=f(Y) The two (Tdmm+Pdmm) are combined and called Transactions ddmm: TDMM=Tdmm+Pdmm What therefore is the main determinant of transactions demand for money?

Speculative Demand for Money This is the amount of money (out of total the demand for money) economic agents use to buy financial assets (investment) like bonds. Why do economic agents buy bonds? The price of bond is inversely related to the interest rate on the bond, given the fixed yield on the bond. Price of bond=yield on bonds/interest rate on bond P b =y/r b, P b = bond price y = bond yield=fixed interest income on bond r b = interest rate on bond

Speculative Demand for Money There is therefore a negative relationship between the price of bond and the interest rate Can you deduce the relationship b/n the demand for bonds and the interest rate? Can you also deduce the relationship b/n the demand for bonds and the demand for money? Finally, can you deduce the relationship b/n the speculative demand for money and the interest rate?

The Speculative Demand for Money and the Interest Rate Given the negative relationship between SDM and the interest rate, we can specify ff function: SDM=f(r) so the sdm is a negative function of the interest rate How is total demand for money and its curve determined? L= TDMM(Y)+SDM(r) There are thus three variables (L, Y, r) to be plotted on a 2-variable quadrant.

The Money demand Curve To plot the money demand curve, we assume income constant so we can plot the function with interest rate on the vertical axis and money demand on the horizontal. Thus there is a downward sloping demand for money curve plotted against the interest rate. What then causes the demand for money curve to shift: A change in income and exogenous change in money demand.

The Money demand Curve An increase in income shifts the curve to the right as demand for money balances increases with income. Exogenous change in money demand because people s demand more money at festive seasons for instance cause the curve to shift to the right.

Determinants of the interest rate 1. Changes in Money Supply 2. Changes in demand for money 3. Both 1 & 2 Changes in the money supply and r Changes in money demand and r

The Equilibrium Interest Rate M D M S i 0 E 0 M 0 Quantity of Money

The Equilibrium Interest Rate The equilibrium interest rate arises where demand for money equals supply of money. A given amount of money, M 0, is shown by the vertical supply curve M s. The demand for money is M d ; its negative slope indicates that a fall in the rate of interest causes the quantity of money demanded to increase. Equilibrium is at E 0, with a rate of interest i 0..

The Equilibrium Interest Rate M D M S i 0 E 0 i 1 M 0 M 1 Quantity of Money

The Equilibrium Interest Rate If the interest rate is i 1, there will be an excess demand for money of M 1 -M 0. Bonds will be offered for sale in an attempt to increase money holdings. This will force the rate of interest up to i 0 (the price of bonds falls), at which point the quantity of money demanded is equal to the fixed supply, M 0. If the interest rate is i 2, there will be an excess money balance. This will force the rate of interest down to i 0 (the price of bonds rises), at which point the quantity of money demanded has risen to equal the fixed money supply, M 0.

The Equilibrium Interest Rate M D M S i 2 i 0 E 0 i 1 M 2 M 0 M 1 Quantity of Money

Numerical Illustration L=0.25Y-12.5r Ms=400 A) Find r* if Y=2000 B) What happens to r when Y increases by 100? Illustrate with money market diagrams C) Find the new r* D) What happens to r* when Ms increases to 450?

Interest Rates and Money Supply Changes M D M S i 0 E 0 E 1 i 1 M 0 M 1 Quantity of Money

Interest Rates and Money Supply Changes A change in the policy-determined interest rate requires the money supply to change. In the figure the initial money supply is shown by the vertical line M s 0, and the demand for money is shown by the negatively sloped curve M d. The initial equilibrium is at E 0, with corresponding interest rate of interest i 0.

Interest Rates and Money Supply Changes The monetary authorities choose to lower the interest rate from i 0 to i 1. In order to achieve this they must generate an increase in the money supply, from M s 0 to M s 1. The new equilibrium is at E 1. Starting at E 1, with M s 1 and i 1, it can be seen that a decrease in the money supply to M s 0 would be required to achieve an increase in the interest rate from i 1 to i 0.

The Effect of Changes in the Interest Rate Investment Spending M D M S 0 M S 1 I D i 0 E 0 i 0 A i 1 E 1 i 1 B 0 M M 0 0 1 I 0 I 1 Quantity of Money Investment expenditure (i). Money Demand and Supply (ii). The investment demand function I

The Effect of Changes in the Interest Rate Investment Spending A reduction in the rate of interest increases desired investment expenditure. Initial equilibrium is at E 0, with a quantity of money of M 0 (shown by the vertical money supply curve M s 0), an interest rate of i 0 (point A in part (ii)). The monetary authorities then lower the interest rate to i 1 (and increase the money supply to M 1 ), and this increases investment expenditure from Δl to l 1 (point B). A policy-induced rise in the interest rate from i 0 to i 1 is accompanied by a fall in the money stock from M 1 to M 0 and leads investment to fall by Δl from l 1 to l 0.

The Effects of Changes in the Interest Rate on Aggregate Demand AE = Y E 0 AE 0 I (i). Shift in Aggregate Expenditure 45 o 0 AD 1 Y 0 Real GDP E 0 P 0 (ii). Shift in Aggregate Demand Y 0 Real GDP

The Effects of Changes in the Interest Rate on Aggregate Demand AE = Y E 1 AE 1 E 0 AE 0 I (i). Shift in Aggregate Expenditure 45 o 0 AD 1 Y 0 Y 1 Real GDP AD 0 E 0 E 1 P 0 (ii). Shift in Aggregate Demand Y 0 Y 1 Real GDP

The Effects of Changes in the Interest Rate on Aggregate Demand Changes in the interest rate cause shifts in the aggregate expenditure and aggregate demand functions. A fall in the interest rate increased desired investment expenditure by Δl. Here, in part (i) the aggregate expenditure function shifts up by Δl, from AE 0 to AE 1. At the fixed price level P 0, equilibrium GDP rises from Y 0 to Y 1, shifting the aggregate demand curve horizontally from AD 0 to AD 1 in part (ii).