Outline:

•Why agents wish to hold money

•The portfolio choice

•The demand for money

•Changes in the demand for money

•Bond prices and yields—why they move inversely

•The supply of money

•Equilibrium in the money market

•How the money market reaches equilibrium.

•Effects of FED open market operations.

•To make transactions

•To be prepared for contingencies—accidents, lawsuits, e.g.

•To store wealth—as an alternative to bonds, equities, jewelry, farmland, etc.

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.”

The Demand for Money (MD)

The demand for money (MD) depends on:

•The nominal interest rate

•The price level

•Real GDP

•Financial technology

MD is positively related to the price level and real GDP, ceteris paribus. Also,

MD is inversely related to the nominal interest

rate, ceteris paribus.

Nominal Interest Rate (%)

Money($Trillions)

0

MD

E

F3%

6%

1.0 1.2

Demand for Money •As we move along MD, the

price level and real GDP 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.

Nom

inal

In

tere

st R

ate

(%)

Money($Trillions)

0

MD1

E

F3%

6%

1.0 1.2

Effect of a Change in Price Level (P) or Real GDP (Y)

MD2

1.12 1.5

MD1 MD2

•Increase in P, ceteris paribus.

•Increase in Y, ceteris paribusG

H

Bond Prices and the Rate Of Interest

Bond prices and interest rates (or

yields), move inversely

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

•The supply of money schedule reveals the stock of money available to satisfy the demand for money at various nominal 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.

Money($Trillions)

0

3%

6%

1.0 1.2

Supply of Money (MS)

J

E

MS1 MS2 Ms1 Ms

2

•Decrease of the required reserve ratio

• Decrease of discount rate

•Open market purchase of government securitiesN

omin

al I

nte

rest

Rat

e (%

)

Money($Trillions)

0

3%

6%

1.0 1.04

Equilibrium in the Money market

E

MS

MD

7%

0.9

•When r = 7%, MS > MD by $100 billion.

•When r = 3%, MD > MS by $400 billion.

•When r = 6%, MS = MD

Nom

inal

In

tere

st R

ate

(%)

When there is an excess supply of money in the economy, there is also an excess demand for bonds

Interest rate higher than

equilibrium

Excess supply of

money

Excess demandforbonds

Publicbuys bonds

Price of bonds rises

Money($Billions)

0

MS1 MS2

MD

E

F

6%

4%

1.0 1.02

FED open market purchases bid up the prices of bonds, and drive yields down.

Open Market Operations and the Money Market

Nom

inal

In

tere

st R

ate

(%)

Money($Trillions)

0

MS0 MS1

MD

E

F

8%

6%

0.9 1.0

Nom

inal

In

tere

st R

ate

(%) FED open

market sales depress bond prices, and drives yields upward.

Fed “Pulls the String”