Unformatted text preview: nly alternative asset to money in Keynes’s framework, have an expected return equal
to the interest rate i.2 As this interest rate rises (holding everything else unchanged),
the expected return on money falls relative to the expected return on bonds, and this
causes the demand for money to fall.
We can also see that the demand for money and the interest rate should be negatively related by using the concept of opportunity cost, the amount of interest
(expected return) sacrificed by not holding the alternative asset—in this case, a bond.
As the interest rate on bonds i rises, the opportunity cost of holding money rises, and
so money is less desirable and the quantity of money demanded must fall.
Figure 1 shows the quantity of money demanded at a number of interest rates,
with all other economic variables, such as income and the price level, held constant.
At an interest rate of 25%, point A shows that the quantity of money demanded is
$100 billion. If the interest rate is at the lower rate of 20%, the opportunity cost of
money is lower, and the quantity of money demanded rises to $200 billion, as indicated by the move from point A to point B. If the interest rate is even lower, the quantity of money demanded is even higher, as is indicated by points C, D, and E. The curve
Md connecting these points is the demand curve for money, and it slopes downward.
At this point in our analysis, we will assume that a central bank controls the
amount of money supplied at a fixed quantity of $300 billion, so the supply curve
for money Ms in the figure is a vertical line at $300 billion. The equilibrium where
the quantity of money demanded equals the quantity of money supplied occurs at the
intersection of the supply and demand curves at point C, where
Md Ms The resulting equilibrium interest rate is at i* (3)
15%. 2Keynes did not actually assume that the expected returns on bonds equaled the interest rate but
rather argued that they were closely related. This distinction makes no appreciable difference in our
analysis. Supply and Demand in the Market for Money: The Liquidity Preference Framework W-31 Interest Rate, i
30 25 Ms
A B 20 C i * = 15 D 10 E 5 Md
0 Figure 1 100 200 300 400
Quantity of Money, M
($ billions) Equilibrium in the Market for Money We can again see that there is a tendency to approach this equilibrium by first
looking at the relationship of money demand and supply when the interest rate is above
the equilibrium interest rate. When the interest rate is 25%, the quantity of money
demanded at point A is $100 billion, yet the quantity of money supplied is $300 billion. The excess supply of money means that people are holding more money than
they desire, so they will try to get rid of their excess money balances by trying to buy
bonds. Accordingly, they will bid up the price of bonds, and as the bond price rises,
the interest rate will fall toward the equilibrium interest rate of 15%. This tendency is
shown by the downward arrow drawn at the interest rate of 25%.
Likewise, if the interest rate...
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