The Money Market and the Interest Rate
© 2003 South-Western/Thomson Learning
Individuals’ Demand for Money An individual’s quantity of money demanded is the amount of wealth that the individual chooses to hold as money, rather than as other assets.
Individuals’ Demand for Money
When you hold money, you bear an opportunity cost - the interest you could have earned.
Individuals’ Demand for Money
Simplifying Assumption: Individuals choose how to divide wealth between two assets: • • money, which can be used as a means of payment but earns no interest, and bonds, which earn interest but cannot be used as a means of payment.
Individuals’ Demand for Money
How much money an individual will decide to hold is determined by: •The Price Level •Real Income •The Interest Rate
The Money Demand Curve Money Demand Curve A curve indicating how much money will be willingly held at each interest rate
The Money Demand Curve
Interest Rate
The money demand curve is drawn for a given real GDP and a given price level. At an interest rate of 6 percent, $500 billion of money is demanded.
6%
E
If the interest rate drops to 3 percent, the quantity of money demanded increases to $800 billion.
3%
F
Md 500 800 Money ($ Billions)
Shifts in the Money Demand Curve
A change in the interest rate moves us along the money demand curve. A change in money demand caused by something other than the interest rate (such as real income or the price level) will cause the curve to shift.
Shifts in the Money Demand Curve
Interest Rate
An increase in real GDP or in the price level will shift the money demand curve rightward.
At any interest rate, more money will be demanded after the shift.
6%
E
G
3%
F
H
d d
M1 500 700 800 1,000
M2
Money ($ Billions)
The Supply of Money Money Supply Curve A line showing the total quantity of money in the economy at each interest rate The money supply is determined by the Federal...