14.7 Interest Rates

How does the Fed influence the economy?

By changing the money supply (M1 and M2), which affects interest rates and economic activity.

The public wants to hold some of its wealth as money for two main reasons:

To facilitate purchases (transactions).

To hold as an asset (store of value).

What is interest?

The price paid for the use of money — compensation for delaying purchasing power.

How is the interest rate determined?

By the interaction of money demand and money supply — like any market price.

What is transactions demand for money?

Money held to make purchases — for groceries, bills, wages, etc

What determines transactions demand?

Nominal GDP — more spending means more money needed.

Why is the Dt curve vertical?

It’s assumed to be independent of interest rates — people need money to spend regardless of rates.

Dt formula

Nominal GDP / Velocity of Money

If nominal GDP is $300 billion and each dollar is spent 3 times, how much money is needed for transactions?

$100 billion.

What happens to Dt if nominal GDP rises to $450 billion?

Dt shifts right to $150 billion.

More spending in the economy

Dt shifts right (people need more money to buy more stuff)

Less spending in the economy

Dt shifts left (people need less money to buy less stuff)

What is asset demand for money?

Money held as a store of value — for safety, liquidity, and buying opportunities.

Why might someone hold money instead of bonds?

Money is safer and more liquid, even though it earns little or no interest.

What is the opportunity cost of holding money?

The interest you could earn from bonds or other assets.

How does interest rate affect asset demand?

Inversely — higher interest rates reduce asset demand for money.

Why does the Da curve slope downward?

Because lower interest rates reduce the opportunity cost of holding money.

What is total money demand (Dm)?

The sum of transactions demand (Dt) and asset demand (Da).

How is Dm graphed?

As a downward-sloping curve — combining Dt (vertical) and Da (sloped)

What causes Dm to shift?

Changes in nominal GDP — because Dt depends on GDP.

If nominal GDP increases, what happens to Dm?

It shifts right — more money needed for transactions.

What is the equilibrium interest rate?

The rate where money demand equals money supply.

Why is the money supply curve vertical?

Because the Fed sets a fixed amount of money in the short run.

What happens when the Fed increases the money supply?

Interest rate falls.

What happens when the Fed decreases the money supply?

Interest rate rises.

Velocity of Money

Number of times a dollar is spent in a year to buy goods and services

Transactions Demand Formula

Nominal GDOP / Velocity of Money

What is the relationship between interest rates and bond prices?

They are inversely related — when interest rates rise, bond prices fall; when interest rates fall, bond prices rise.

Why do bond prices fall when interest rates rise?

Because new bonds offer higher returns, making older, lower-paying bonds less attractive unless sold at a discount.

Why do bond prices rise when interest rates fall?

Because older bonds pay more than new ones, so buyers are willing to pay more for them.

What is the formula for bond yield?

Yield = Annual Payment / Price Paid x 100

What is the formula for price?

Price = annual payment / yield x 100

If a bond pays $50 annually and sells for $1,000, what is the yield?

50 / 1000 × 100 = 5%

If interest rates rise to 7.5%, what happens to the price of a $50 bond?

It falls to $667 so that: 50/667 = 7.5%

If interest rates fall to 2.5%, what happens to the price of a $50 bond?

It rises to $2,000 so that:
50/2000 = 2.5%

What does the seesaw analogy represent?

Mr. Bond (price) and Mr. Rate (interest) sit on opposite ends — when one goes up, the other goes down.

What is the yield if you pay $100 for a $50 bond?

50/100 × 100 = 50%

What is the yield if you pay $500 for a $50 bond?

50/500 × 100 = 10%

What is the yield if you pay $5,000 for a $50 bond?

50 / 5000 × 100 = 1%

What happens to yield as bond price increases?

Yield decreases — you’re paying more for the same fixed return.

What happens if prices rise or real output increases?

Households will desire more money for transactions.

What is the term for the demand for money as a medium of exchange?

Transactions demand for money

What does it mean when someone holds money to buy the dips?

Money can be used to immediately purchase other assets at opportune times.

The money supply is represented by a vertical line in the figure because the monetary authorities and financial institutions have provided the economy with _________

Some particular stock of money

In the market for money, the intersection of demand and supply determines the _______

• equilibrium interest rate

• equilibrium price of money

An increase in the supply of money will do what to the equilibrium interest rate?

LOWER

A decrease in the supply of money will do what to the equilibrium interest rate?

HIGHER

What type of relationship exists between bond prices and interest rates?

INVERSE

What type of relationship exists between bond prices and interest rates?

When the interest rate increases, bond prices fall; when the interest rate decreases, bond prices rise.

Bonds are sold in __________ markets.

Financial

The intersection of demand and supply determines the _________

Equilibrium price for money

A decrease in the supply of money will _________ the equilibrium interest rate

Raise

An increase in the money supply will ______ the equilibrium interest rate

Lower

A decrease in the money supply will _______ the equilibrium interest rate.

Rais