Money, Interest Rates - International Economics - Lecture Slides, Slides of Economics

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Money, Interest

Rates, and

Exchange Rates

Preview

• What is money?
• The supply of money
• The demand for money
• Equilibrium in the money market

What Is Money? No Return

• We can classify all assets into:

 Money, which earns no return

• Currency with the public, checking accounts

 Assets that earn a return

• Stocks, bonds, real estate, etc.

What Is Money? High Liquidity

• Money is very liquid :

 that is, it can easily and quickly be used to purchase goods and services.

• Assets that earn a return are less liquid

Money Demand

• Money demand is the amount of their wealth that

people are willing to hold in the form of money

 (instead of other assets that are less liquid but earn a return).

• What influences our willingness to hold money?

What Influences Aggregate

Demand for Money?

1. Interest rates : money pays little or no interest. So, the interest rate on non-money assets (such as bonds) is the opportunity cost of holding money (instead of non-money assets).  A higher interest rate means a higher opportunity cost of holding money  lower money demand. 2. Prices : the prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions.  A higher price level means a greater need for liquidity to buy the same amount of goods and services  higher money demand.

A Model of Aggregate Money Demand

The aggregate demand for money can be expressed by:

Md^ = P x L ( R,Y ) (15-1)

where:

P is the price level Y is real national income R is the interest rate L ( R,Y ) is the aggregate real money demand ( Md/P )

Functional Notation

• L is the real aggregate demand for money ( Md/P )
• L ( R,Y ) is a concise mathematical way of saying “ L

depends on R and Y .”  Some people say, “ L is a function of R and Y .” This is why L ( R,Y ) is said to be an instance of functional notation.

• If Y is constant, L and R are inversely related: when

one increases the other decreases

• If R is constant, L and Y are directly related: when one

increases so does the other

A Model of Aggregate Money Demand

Fig. 15-1: Aggregate Real Money

Demand and the Interest Rate

For a given level of income, real money demand ( M d/ P ) decreases as the interest rate increases.

The Money Market

• Equilibrium in the money market requires:

Ms^ = Md^ (15-3)

• Alternatively, equilibrium requires the supply of real

money be equal to the demand for real money (by dividing both sides by the price level):

Ms/P = L ( R,Y ) (15-4)

Fig. 15-3: Determination of the

Equilibrium Interest Rate

L ( R , Y )

P

M

s