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MODULE 28: THE MONEY MARKET

The purpose of this module is to introduce the money market. This money market, and the liquidity preference model, is the foundation for understanding how the Fed’s monetary policy affects interest rates. The money market is simply another use of demand and supply. While the money supply is fixed and determined by the central bank, money demand is inversely related to the short-term, or nominal, interest rate.

Student learning objectives:

• What the money demand curve is.

• Why the liquidity preference model determines the interest rate in the short run.

Key Economic Concepts For This Module:

• People hold (demand) money (think M1) primarily to make transactions. The other alternative is to save the money in interest-bearing assets. When money is held as M1, earned interest is forgone, thus the short-term (or nominal) interest rate is the opportunity cost of holding money.

• As the nominal interest rate rises, the opportunity cost of holding money rises, so the quantity of money held (demanded) falls. Thus the money demand curve is downward sloping with the nominal interest rate plotted on the vertical axis.

• Money demand will shift to the right if: the aggregate price level rises, real GDP rises, technology is slow to improve, and if banking institutions become less reliable.

• The liquidity preference model of the interest rate says that the nominal interest rate is determined by the intersection of supply and demand for money in the market for money.

• The model assumes that the supply of money is vertical and chosen by the Fed and that the demand for money is downward sloping. The key graph of this module is below.

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Common Student Difficulties:

• We have done a good job of training students to think that the real interest rate is what really matters. This is true for long-term investments or projects. In the case of the money market, money demand in particular has a short-term horizon. The model assumes that there is no inflation, so the nominal interest rate is used on the vertical axis.

• Students often think that the desirable quantity of money demand is infinity! Surely there is no limit to how much money I would demand. Stress to the students that even the wealthiest of persons doesn’t walk around with all of his/her money in a pocket or checking account. There is an opportunity cost of holding money and most people understand that.

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In-Class Presentation of Module and Sample Lecture

Suggested time: This module can be adequately covered in one hour-long class session.

I. The Demand for Money

A. The Opportunity Cost of Holding Money

B. The Money Demand Curve

C. Shifts of the Money Demand Curve

1. Changes in the Aggregate Price Level

2. Changes in Real GDP

3. Changes in Technology

4. Changes in Institutions

AI. Money and Interest Rates

A. The Equilibrium Interest Rate

B. Two Models of the Interest Rate

I. The Demand for Money

Note: ask the students why they would want to have money in their pockets. The answer seems simple, but it can be more complex than, “I have money in my pocket to buy things.”

What would cause you to have more money in your pocket today than you had yesterday? I need to buy more things today. Or things today are more expensive than they were yesterday.

Indeed, people hold money so that they can buy things. Now ask the students what else you can do with your money. You can save it! And what would make you interested in saving it? A higher interest rate. This prepares the way to discuss the opportunity cost of holding money.

A. The Opportunity Cost of Holding Money

It is convenient to hold money in your pocket because it allows you to conveniently make purchases. The price of that convenience is that money in your pocket earns no interest.

Suppose you could put $100 in a 12-month CD that would earn 5%. A CD is not very liquid because if you withdraw the money before 12 months, you forfeit most of the interest.

$100 in your pocket or in your checking account (M1) will come at an opportunity cost of 5% or $5. Maybe it is easy to pass up $5 to have the convenience of $100 in your pocket.

What if the interest rate was 50%? Would you still hold $100 in your pocket when the cost is now $50?

If the interest rate was 0.5%, how likely is it that you would you put the $100 in the CD? Not very.

Intuitively, this reflects a general result: the higher the short-term interest rate, the higher the opportunity cost of holding money; the lower the short-term interest rate, the lower the opportunity cost of holding money.

Why don’t we consider long-term interest rates like 10 -year CD’s as the opportunity cost of holding money? Because we hold money to make transactions in the short term. Therefore we must consider the opportunity cost in the short term, not the long term.

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B. The Money Demand Curve

Since we demand money to make purchases in the short term, the opportunity cost of holding money is the short-term interest rate.

We assume that in a short period of time, there will be virtually no inflation, so the nominal interest rate is equal to the real interest rate.

Note: it is this assumption that allows us to put the nominal interest rate on the vertical axis of graph of the money market. Students may lose points on the AP exam if they label this axis as the real interest rate.

As discussed above, when the interest rate rises, the opportunity cost of holding money rises, so the quantity of money demanded will fall.

The money demand curve is downward sloping.

An increase in the nominal interest rate will cause a movement upward along the money demand curve.

C. Shifts of the Money Demand Curve

Just like there are external factors that shift the demand curve for pomegranates, there are external factors that shift the demand curve for money.

Note: stress to the students that, if an external change makes holding money in your pocket more desirable at any interest rate, the demand curve for money will shift rightward.

The most important factors causing the money demand curve to shift are changes in the aggregate price level, changes in real GDP, changes in banking technology, and changes in banking institutions.

1. Changes in the Aggregate Price Level

All else equal, higher prices increase the demand for money (a rightward shift of the MD curve), and lower prices reduce the demand for money (a leftward shift of the MD curve).

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We can actually be more specific than this: other things equal, the demand for money is proportional to the price level. That is, if the aggregate price level rises by 20%, the quantity of money demanded at any given interest rate, also rises by 20%.

Why? Because if the price of everything rises by 20%, it takes 20% more money to buy the same basket of goods and services.

2. Changes in Real GDP

As the economy gets stronger, real incomes and real GDP rise.

The larger the quantity of goods and services we buy, the larger the quantity of money we will want to hold at any given interest rate.

So an increase in real GDP—the total quantity of goods and services produced and sold in the economy— shifts the money demand curve rightward.

3. Changes in Technology

Changes in technology can affect the demand for money. In general, advances in information technology have tended to reduce the demand for money by making it easier for the public to make purchases without holding significant sums of money.

If there was an ATM machine on every corner and in every retail store and restaurant, there would be little need to hold money in your pocket.

4. Changes in Institutions

Regulations that make it more attractive to keep money in banks will reduce the demand for money.

If a nation’s political and banking systems became dangerously unstable, it might increase the demand for money because people would rather hoard their money than store it in institutions that might be falling apart.

AI. Money and Interest Rates

The Fed uses the three tools of monetary policy to achieve a target level for the federal funds rate. Since most interest rates will move closely with the FFR, we can use the money market to show how these policies work.

A. The Equilibrium Interest Rate

We assume that the money supply MS is determined by the Fed and is fixed at any given point in time. It is also independent of the interest rate so it is depicted as a vertical line.

Note: To understand how the interest rate is determined, illustrate the liquidity preference model of the interest rate. This model says that the interest rate is determined by the supply and demand for money in the market for money.

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Note: it will be helpful to students if we think of only two places to put your money. You can put money in CDs that provide interest, or you can hold cash that earns no interest.

Discuss equilibrium by discussing interest rates above and below i*.

Example What would happen to interest rates and the quantity of money demanded if there was some interest rate i1 that was greater than i*?

If i1 > i*, the quantity of money supplied exceeds the quantity of money demanded. Why? Because of high interest rates, CDs are very attractive saving options!

In fact, banks find that they can lower the interest rate on CDs and still have plenty of customers ready to buy a CD. As interest rates fall, the quantity of money demanded gets closer and closer to M*.

Example What would happen to interest rates and the quantity of money demanded if there was some interest rate i2 that was less than i*?

If i2 < i*, the quantity of money demanded exceeds the quantity of money supplied. Why? Because of low interest rates, CDs are not very attractive saving options!

In fact, banks find that they must raise the interest rate on CDs to get more customers ready to buy a CD. As interest rates rise, the quantity of money demanded gets closer and closer to M*.

B. Two Models of the Interest Rate

The model of liquidity preference describes equilibrium in the money market. This model is a good foundation for learning a similar market in loanable funds that is also useful in describing how interest rates are determined and the impact of monetary policy and other more advanced topics.

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In-Class Activities and Demonstrations

Note: the instructor might choose to do this exercise at the beginning of this module to see if student behavior corresponds to the assumptions of a downward sloping money demand curve. It will help to provide the students with the table below and a sheet of graph paper.

A Budgetary Exercise

Imagine you have $2000 each month to cover your living expenses. Items like rent, insurance and utilities are fixed every month and total $1200. Items like food, clothing, and entertainment can fluctuate depending upon your tastes and desires, but the bare minimum amount of food+clothing+entertainment (FCE) will cost you $ 200 each month. If you have paid all of your bills and there are additional dollars in your budget, you can save this money in the bank and earn some interest income. The interest rate fluctuates from month to month.

The table below allows you to make some spending and saving choices over the next six months. You will see your income and fixed expenses are already completed for you. You must consider how much money you wish to spend on FCE (minimum of $200) and how much you wish to save.

|Month |Interest Rate |Income = |Fixed expenses + |Variable expenses |Savings |

| |on Savings | | |(FCE) + | |

| |at the bank | | | | |

|January |10% |$2000 = |$1200 | | |

|February |6% |$2000 = |$1200 | | |

|March |2% |$2000 = |$1200 | | |

|April |20% |$2000 = |$1200 | | |

|May |15% |$2000 = |$1200 | | |

|June |0.5% |$2000 = |$1200 | | |

Now that you have completed the table, create a graph that puts the interest rate on the vertical axis and the amount of money you would spend on FCE on the horizontal axis. Plot the six points and describe any trends you might see. What do you suppose explains why the graph turned out the way it did?

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250 Section 5: Financial Sector

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