4.5 The Money Market

Demand for Money

1. Transaction Demand

2. Precautionary Demand

3. Asset Demand for Money

Transaction demand

people hold money for everyday transactions

precautionary demand

people hold onto money “just in case”

asset demand for money

people hold money since it is less risky than other assets (bonds, stocks, etc.)

opportunity cost of holding money in your pocket/checking account

interest you could have made from other financial assets (stocks, bonds, real estate)

Interest Rates vs Quantity of money demanded Relationship

inverse relationship between interest rate and quantity of money demanded

(explains why MD curve is sloping downwards)

Money Demand Shifters

1. changes in price level

2. changes in national income (personal income)

3. changes in technology (if easier to convert less liquid assets, less money is demanded)

Supply of Money

the Federal Reserve System (FED) is a nonpartisan gov office that sets and adjusts the money supply to adjust the economy

Why is MS vertical?

supply of money is NOT impacted by the interest rate

FED sets it wherever they want

Federal Reserve

created in 1913, the FED’s job is to regulate banks and ensure people have faith in financial systems

use MONETARY POLICY to change money supply and help inflationary or recessionary gaps

Market Equilibrium

occurs when the Nominal Interest rate (ir_e) is set where the current money supply (MS) intersects the current demand for money (MD)

draw money market in SURPLUS

ir is above ir_e, arrow pointing downwards along MD towards equilibrium

QM₁ < QM_e

draw money market in SHORTAGE

ir is below ir_e, arrow pointing upwards along MD towards equilibrium

QM₁ > QM_e