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# Ch5 - Money and Interest Rates Choosing between consumption...

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Money and Interest Rates Choosing between consumption and savings

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The Market Interest Rate What determines the equilibrium interest rate in financial markets? A financial market is any market in which borrowers and lenders interact The supply of funds being forwarded by lenders and the demand for funds by borrowers determines both the quantity of lending/borrowing and the interest rate at which these loans are made. One way to analyze this market would be to directly examine the supply and demand for bonds (loans). An alternative method would be to examine the supply and demand for money
The Liquidity Preference Framework There are essentially two things you can do with your wealth: Spend it using money Save it by purchasing bonds Breaking down wealth into these two broad asset categories yields the following identity: B S + M S = B D + M D Equilibrium in the bond market will be achieved when B S = B D . The interest rate will adjust until the quantity of bonds supplied is equal to the quantity of bonds demanded. At the equilibrium interest rate, B S = B D Rearranging the identity above: B S – B D = M D – M S At equilibrium, B S – B D = 0, so… M S = M D When the bond market is in equilibrium, the supply of money is equal to the demand for money We can find the equilibrium interest rate by looking only at the money market!

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The Demand for Money and Interest Rates We assume that if you hold your wealth as money, you earn no interest, while you do earn interest if you hold your wealth as bonds.
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