Money Demand Equilibrium Interest Rate Part II Unit

Money Demand, Equilibrium Interest Rate – Part II - - Unit 5, Case & Fair (chapter 24), B. Com (P), Principles of Macro Economics - Part II - Prepared by Dr. Charu Grover Assistant Professor, Shaheed Bhagat Singh College Department of Economics

The Total Demand for Money Ø The total quantity of money demand is the sum of the demand for checking account balances and cash by both households and firms. Ø Like households, firms need cash for their ordinary transactions as they deal with public and they receive cash and checks for sales. Ø The tradeoff for households and firms is the choice between money (no interest) and bonds (interest bearing assets). Ø For both households and firms: Higher interest rate Higher opportunity costs of money Lower demand for money

Transactions Volume and Money Demand Ø Figure 1 (in next slide) shows money demand curve as a function of interest rate, for given level of income (Y). Ø If there is increase in value of income say from Rupees 1200 to Rupees 1500. The higher income leads to increase in spending and thereby, increase in transactions. Thus, it leads to increase in demand for money (shown by rightward shift in the money demand curve in figure 1). Ø If there is decrease in value of income say from Rupees 1200 to Rupees 900. The lower income leads to decrease in spending and thereby, decrease in transactions. The money demand curve shifts leftward with decrease in income.

Transactions Volume and Money Demand Figure 1: Money Demand Curve for given income

Transactions Volume and the Price Level Ø The money needed by firms and households to facilitate their daily transactions depends on the average dollar amount of each transaction. The average amount of each transaction depends on the price level. Ø For example, if wage rate rises, firms needs more money to carry out their daily transactions. If price of lunch rises, households will be requiring more money. Even though the number of transactions may not have changed, the quantity of money needed to engage in these transactions have risen. Therefore, they need to keep more money in their checking account. Ø Change in Price level • Increase in price level • Decrease in price level Money demand curve shifts to right Money demand curve shifts to left

Determinants of Money Demand Ø Interest Rate – Negative effect on money demand, i. e, increase in interest rate implies decrease in money demand Ø Dollar value of Transactions – Ø Income- Positive effect on money demand, i. e. , increase in income implies increase in money demand ØPrice Level- Positive effect on money demand, i. e. , increase in price level implies increase in money demand

Some Common Pitfalls Ø Money demand is a stock variable and is measured at a given point in time. It is not a flow measure like other demand say demand for coffee is a flow variable (three cups per day or three cups per week) Ø Money demand savings is not the same. For example, • If in a given year household has a income of Rupees 100000 and expenses of Rupees 90000. It saved Rupees 10000 in the year. • At the beginning of the year, the household had no debt and Rupees 200000 in assets. As households saved Rupees 10000 during the year. Therefore, it has Rupees 210000 in assets at the end of the year. Out of Rupees 210000 some of it is held in the form of bonds, some in the form of money. The amount household in the form of money is the demand for money. Ø Changes in the interest rate causes movement along the money demand curve. However, changes in income or price level causes shifts in the money demand curve.

Equilibrium Interest Rate How is interest rate determined in the economy? The equilibrium interest rate in the economy is determined at the point where the quantity of money demanded equals the quantity of money supply.

Supply of Money ØFed controls the money supply through its manipulation of the amount of reserves in the economy ØAssume money supply does not depend on the interest rate ØFed uses its three tools – required reserve ratio, discount rate and open market operations to achieve the fixed target for the money supply The money supply curve is vertical

Equilibrium – Supply and Demand in Money Market Figure 2: Equilibrium in Money Market

Equilibrium – Supply and Demand in Money Market Ø In Figure 2, the equilibrium interest rate is r*, which is given at a point where demand supply of money is equal Ø Adjustment Mechanism – • At high interest rate r 0, the quantity of money supply exceeds the quantity of money demand (Mod) - there is more money in circulation than households and firms want too hold. Therefore, interest rate falls, thereby leading to firms and households to reduce money holdings and buy bonds. • At low interest rate r 1, the quantity of money demand (M 1 d) exceeds the quantity of money supply - there is more money in circulation than households and firms want too hold. Therefore, interest rate falls, thereby leading to firms and households to reduce money holdings and buy bonds.

Effect of Increase in Money Supply on Interest Rate Figure 3: Effect of increase in money supply on interest rate

Effect of Increase in Money Supply on Interest Rate Ø Suppose Fed reduces the reserve requirement or cut the discount rate or buy government securities on the open market, thereby leading to increase in money supply (expansionary monetary policy) Ø There money supply curve shifts rightward from Mos to M 1 s (figure 3). Ø At initial interest rate of 14%, there is excess supply of money. This puts downward pressure on the interest rate as households and firms try to buy bonds with their money to earn that high interest rate. The interest rate continues to fall till it reaches new equilibrium interest rate of 7%, where M 1 d = M 1 s. Ø If Fed wants to increase the interest rate, it would contract the money supply (tight monetary policy) by increasing the reserve requirement or raising discount rate or selling government securities. In this case money supply curve shifts to the left and it leads to increase in interest rate.

Effect of Increase in Income on Interest Rate Figure 4: Effect of increase in Income on interest rate

Effect of Increase in Income on Interest Rate Ø Increases in Income leads to more transactions in the economy and the higher demand for money for both firms and households. Ø The money demand curve shifts rightward from Mod to M 1 d. The money supply curve is unchanged (refer Figure 4) Ø Thus, equilibrium interest rate rises from 7% to 14%. Ø Decrease in income shifts the money demand curve leftward and thus, equilibrium interest rate falls. Ø If there is increase in price level, the effect is same as increase in income (Y), i. e. , money demand curve shifts rightward and interest rate rises. As with rise in price level, firms and households needs more money for daily transactions, thereby shifting money demand curve rightward and increasing the interest rate.

Effect of Increase in Price Level on Interest Rate Ø If there is increase in price level, the effect is same as increase in income (Y). Ø As with rise in price level, firms and households needs more money for daily transactions, thereby shifting money demand curve rightward and increasing the interest rate. Ø The decrease in price level leads to decrease in equilibrium interest rate.