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Class 6

# The demand for money is what is left over when

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The demand for money is what is left over when households have met their demand for bonds. In this way, the money market is the residual of the bond market. The total demand for financial wealth is limited by the total supply of financial wealth. This can be expressed as B s + M s = B d + M d 53

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When interest rates are high, households hold more bonds and less money. when interest rates are low, households hold less bonds and more money Econ 350 U.S. Financial Systems, Markets and Institutions Class 6 where B s = bond supply M s = money supply B d = bond demand M d = money demand. then B s - B d = M d - M s If the bond market is in equilibrium, then the money market is in equilibrium. (both sides would equal 0). An excess supply of bonds (B s > B d ) means there is an excess demand for money (M d > M s ), and vice versa. To derive the money demand curve, start with the assumption that interest rates are unexpectedly high compared to the past trend. In this situation, households will expect interest rates to fall closer to average. As interest rates fall, the price of bonds will increase. Households will want to take advantage of these potential capital gains by increasing their bond holdings and reducing their holdings of money. So when interest rates are unexpectedly high, households will want to increase bond holdings and money demand will be less. Similarly, when interest rates are unexpectedly low, households will expect interest rates to be increasing in the future. This means that the price of bonds will be falling, and households will want to sell their bonds to avoid capital losses as bond prices fall. As they sell their bonds, household hold more money. So at low interest rates households want to hold less bonds and more money. All of this means that the demand for money is downward-sloping, like most other demand curves. Figure 6-11 Money demand in the Keynesian model i M d M Equilibrium in the liquidity preference model Once again, equilibrium occurs at the intersection of the supply and demand curves. Remember we started talking about interest rates? In this model interest rates adjust so that money supply equals money demand, or so that households are satisfied holding the 54
excess demand for money → excess supply of bonds → P B ↓ → i↑ excess supply of money → excess demand for bonds → P B ↑ → i↓ Econ 350 U.S. Financial Systems, Markets and Institutions Class 6 quantity of money in circulation. Interest rates will change with changes in either money supply or money demand. Figure 6-12 Equilibrium in the Keynesian model i M s i hi i* i lo M d M If interest rates are not in equilibrium, then forces are put into motion to bring interest rates back into equilibrium. Changes in money demand In the fixed-price Keynesian model, changes in money demand are caused by -- changes in real income -- changes in the price level -- changes in household preferences for holding money. An increase in money demand leads to higher interest rates. A decrease in money demand leads to lower interest rates. Try it and see. That’s plenty for today. Next time we’ll cover yield curves and what’s known as the structure of interest rates. Later! 55
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