Unformatted text preview: lative motive states that people hold money/bonds when
they expect changes in the interest rate.
Ryan W. Herzog (GU) Money March 17, 2014 32 / 41 Money Market Demand for Money The Speculative Demand for Money Bonds serve as a substitute to cash, individuals face a tradeoﬀ.
When interest rates are high (bond prices are low) individuals are
going to speculate that interest rates are likely to fall. A decline in
the interest rate will cause higher bond prices.
At high interest rates (low bond prices) people substitute into bonds
expecting higher future bond prices.
At low interest rates (high bond prices) individuals are going to
speculate that interest rates are likely to rise. An increase in the
interest rate will cause bond prices to fall.
Instead of holding bonds at low interest rates, risking potential capital
losses, individuals will choose to hold cash. Ryan W. Herzog (GU) Money March 17, 2014 33 / 41 Money Market Demand for Money Changes in the Demand for Money Changes in the interest rate will change the quantity of money
demanded (see speculative motive)
An increase in income or prices (transactional motive) will increase
the demand for money. People with more income, buy more stuﬀ. If
prices are higher you need to hold more money, all else equal.
An increase in uncertainty (i.e. Y2K, ﬁnancial crisis, an increase in
stock market risk) will also increase the demand for money. Ryan W. Herzog (GU) Money March 17, 2014 34 / 41 Money Market Demand for Money An Increase in Money Demand (Figure 11.7)
An increase in income (or prices) will cause money demand to shift
up. Individuals are willing to hold more money at all interest rates. Ryan W. Herzog (GU) Money March 17, 2014 35 / 41 Money Market Money Supply Money Supply We will assume money supply is directly controlled by the Federal
Recall, the Federal Reserve controls bank reserves, which banks then
use to make loans and increase the money supply.
When you hear the term money supply, think of M1.
Money supply will be vertical (perfectly inelastic). Ryan W. Herzog (GU) Money March 17, 2014 36 / 41 Money Market Equilibrium Equilibrium Equilibrium in the money market (the intersection of money demand
and money supply) determines the short-term interest rate.
When interest rates are above equilibrium, money supply will exceed
money demand, investors expect interest rates will fall (and bond
prices will rise) and begin purchasing bonds. An increase in the
demand for bonds will raise bond prices causing interest rates to fall.
When interest rates are below equilibrium, money demand will exceed
money supply, investors expect interest rates will rise (and bond prices
will fall) and begin selling bonds. An increase in the supply of bonds...
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