{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Supply and Demand in the market for the money

Supply and Demand in the market for the money - APPENDIX 4...

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Supply and Demand in the Market for Money: The Liquidity Preference Framework Whereas the loanable funds framework determines the equilibrium interest rate using the supply of and demand for bonds, an alternative model developed by John Maynard Keynes, known as the liquidity preference framework , deter- mines the equilibrium interest rate in terms of the supply of and demand for money. Although the two frameworks look different, the liquidity preference analysis of the market for money is closely related to the loanable funds frame- work of the bond market. 1 The starting point of Keynes’s analysis is his assumption that there are two main categories of assets that people use to store their wealth: money and bonds. Therefore, total wealth in the economy must equal the total quantity of bonds plus money in the economy, which equals the quantity of bonds sup- plied B s plus the quantity of money supplied M s . The quantity of bonds B d and money M d that people want to hold and thus demand must also equal the total amount of wealth because people cannot purchase more assets than their avail- able resources allow. The conclusion is that the quantity of bonds and money supplied must equal the quantity of bonds and money demanded: B s M s B d M d (1) Collecting the bond terms on one side of the equation and the money terms on the other, this equation can be rewritten as B s B d M l M s (2) A P P E N D I X 4 T O C H A P T E R 4 W-29 1 Note that the term market for money refers to the market for the medium of exchange, money. This market differs from the money market referred to by finance practitioners, which is the financial market in which short-term debt instruments are traded.
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
The rewritten equation tells us that if the market for money is in equilibrium ( M s M d ), the right-hand side of Equation 2 equals zero, implying that B s B d , meaning that the bond market is also in equilibrium. Thus it is the same to think about determining the equilibrium interest rate by equating the supply and demand for bonds or by equating the supply and demand for money. In this sense, the liquidity preference framework, which analyzes the mar- ket for money, is equivalent to the loanable funds framework, which analyzes the bond market. In practice, the approaches differ because by assuming that there are only two kinds of assets, money and bonds, the liquidity preference approach implicitly ignores any effects on interest rates that arise from changes in the expected returns on real assets such as automobiles and houses. In most instances, both frameworks yield the same predictions. The reason that we approach the determination of interest rates with both frameworks is that the loanable funds framework is easier to use when analyzing the effects from changes in expected inflation, whereas the liquidity preference framework provides a simpler analysis of the effects from changes in income, the price level, and the supply of money.
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern