The transaction motive states individuals will demand

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

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 Reserve. 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...
View Full Document

This document was uploaded on 03/18/2014 for the course ECON 202 at Gonzaga.

Ask a homework question - tutors are online