Supply and Demand in the market for the money

# Likewise if the interest rate is 5 the quantity of

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Unformatted text preview: is 5%, the quantity of money demanded at point E is \$500 billion, but the quantity of money supplied is only \$300 billion. There is now an excess demand for money because people want to hold more money than they currently have. To try to get the money, they will sell their only other asset—bonds— and the price will fall. As the price of bonds falls, the interest rate will rise toward the equilibrium rate of 15%. Only when the interest rate is at its equilibrium value will there be no tendency for it to move further, and the interest rate will settle to its equilibrium value. Changes in Equilibrium Interest Rates Analyzing how the equilibrium interest rate changes using the liquidity preference framework requires that we understand what causes the demand and supply curves for money to shift. W-32 Appendix 4 to Chapter 4 study guide Learning the liquidity preference framework also requires practicing applications. When there is a case in the text to examine how the interest rate changes because some economic variable increases, see if you can draw the appropriate shifts in the supply and demand curves when this same economic variable decreases. And remember to use the ceteris paribus assumption: When examining the effect of a change in one variable, hold all other variables constant. Shifts in the Demand for Money In Keynes’s liquidity preference analysis, two factors cause the demand curve for money to shift: income and the price level. Income Effect In Keynes’s view, there were two reasons why income would affect the demand for money. First, as an economy expands and income rises, wealth increases and people will want to hold more money as a store of value. Second, as the economy expands and income rises, people will want to carry out more transactions using money, with the result that they will also want to hold more money. The conclusion is that a higher level of income causes the demand for money to increase and the demand curve to shift to the right. Price-Level Effect Keynes took the view that people care about the amount of money they hold in real terms, that is, in terms of the goods and services that it can buy. When the price level rises, the same nominal quantity of money is no longer as valuable; it cannot be used to purchase as many real goods or services. To restore their holdings of money in real terms to its former level, people will want to hold a greater nominal quantity of money, so a rise in the price level causes the demand for money to increase and the demand curve to shift to the right. Shifts in the Supply of Money We will assume that the supply of money is completely controlled by the central bank, which in the United States is the Federal Reserve. (Actually, the process that determines the money supply is substantially more complicated and involves banks, depositors, and borrowers from banks. We will study it in more detail later in the book.) For now, all we need to know is that an increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right. CASE Changes in the Equil...
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## This note was uploaded on 01/02/2013 for the course ECON 102 taught by Professor Lisa during the Spring '09 term at RMIT Vietnam.

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