Money demand and interest rate relationship

Money supply and demand impacting interest rates (video) | Khan Academy

money demand and interest rate relationship

It is the interest lost, if money is held in cash. As the interest rate goes up, the opportunity cost of money goes up, and vice-versa. Money supply, money demand. Individuals want to take advantage of the rising interest rate and choose to hold more bonds, and thus they demand less money. This inverse relationship. The demand for money is the relationship between the quantity of That means the demand for money goes down when interest rates rise.

Before we put this together with the supply of money, we need to go over the relation between the interest rate and the price of bonds. This is because the reason to purchase an asset like a bond and to agree to loan out your money is that your plan to earn an interest on the loan. Thus, the price of a bond is linked to the interest that it promises to give the lender. There are several ways to think about this.

One is to remember that a bond is nothing but a promise to make future payments -- a piece of paper that gives you the right to get certain payments of money at certain future times. The price of a bond is simply the amount of money one can sell it for right now. This will affect both the "primary" market in bonds -- firms selling bonds to raise money to buy capital goods, or government selling bonds to finance a fiscal deficit -- as well as the "secondary" market -- people buying and selling previously-issued bonds.

If I want to buy a one-year bond, then a new one-year bond issued by the U. An "interest rate" is just a different way of discussing the price. To get an interest rate, we subtract the money paid now for the bond from the money the bond promises to pay later, and call that difference "interest.

money demand and interest rate relationship

So if the money that the bond pays in the future is given, then the higher the price in money now of the bond, the lower the difference between that price and what the bond pays later, so the less the interest and hence interest rate. Here is the same idea in more general mathematical language. Now, a bond is basically a promise to pay an amount A at the end of t years.

money demand and interest rate relationship

So, the price you are ready to pay for a bond is really equivalent to the principal you are lending out today to receive repayment in the future. Again, the difference between the price you pay today B and the amount the bond promises to pay you in the future A is equivalent to the interest rate that the bond is effectively going to give you.

Money supply and demand impacting interest rates

You can now see algebraically what we demonstrated in words -- the inverse relationship between the bond price and the interest rate. You can try this with a spreadsheet. A situation in which there is no further pressure for change. Describing equilibrium in the money market will be a matter of describing what the pressures are that will push the interest rate to change.

Monetary Policy Unit: Demand for Money and Interest Rates

Equilibrium will occur whenever the interest rate stops changing. That will be whenever money supply equals money demand. Do not confuse this with a typical micro market equilibrium story of how the price of chicken reaches equilibrium.

That's a flow equilibrium: This is a stock equilibrium: Remember how we discussed equilibrium earlier in section 1. Equilibrium will be a situation in which all the behavioral conditions are satisfied -- when everyone's desired holdings of money equal all the money actually held.

An equilibration process will tell us how the money market actually moves to a situation where everybody manages to meet their desired behavior given from the behavioral functions. The supply of money is the total stock of money available for use in transactions, and held by the private sector. The demand for money balances is the total stock of money that the private sector wishes to hold. Note that when we change the supply of money, as we did in the last chapter, we are changing the amount in deposit accounts.

At any instant in time, all the money has to be somewhere: Let us suppose that we start with a supply of money that does equal the demand for money, at an interest rate of five percent.

Now we increase the supply of money. That means people now hold more money, relative to bonds, than they used to and want to. In an effort to readjust their portfolios, they will seek to turn some of this money into bonds -- they'll buy bonds.

This additional demand for bonds will drive up the price of bonds. As you know from the previous section, a higher price of bonds is the same thing as a lower interest rate. As the interest rate falls, money demand will rise. Once it rises to equal the new money supply, there will be no further difference between the amount of money people hold and the amount they wish to hold, and the story will end. This is why and how an increase in the money supply lowers the interest rate.

Now we decrease the supply of money. That means people now hold less money, relative to bonds, than they used to and want to. In an effort to readjust their portfolios, they will seek to turn some of their bonds into money -- they'll sell bonds.

These additional sales of bonds will drive down the price of bonds. As you know from the previous section, a lower price of bonds is the same thing as a higher interest rate. As the interest rate rises, money demand will fall.

Once it falls to equal the new money supply, there will be no further difference between the amount of money people hold and the amount they wish to hold, and the story will end. This is why and how a decrease in the money supply raises the interest rate. We have a notion of how the interest rate affects demand to hold money which is shown in the downward-sloping money demand curve. When interest rates fall, people hold more money.

The quantity of money households want to hold varies according to their income and the interest rate; different average quantities of money held can satisfy their transactions and precautionary demands for money. It spends an equal amount of money each day. One way the household could manage this spending would be to leave the money in a checking account, which we will assume pays zero interest.

money demand and interest rate relationship

Consider an alternative money management approach that permits the same pattern of spending. The bond fund approach generates some interest income. There may also be fees associated with the transfers.

Of course, the bond fund strategy we have examined here is just one of many. The household could also maintain a much smaller average quantity of money in its checking account and keep more in its bond fund.

For simplicity, we can think of any strategy that involves transferring money in and out of a bond fund or another interest-earning asset as a bond fund strategy. Which approach should the household use?

Demand, Supply, and Equilibrium in the Money Market

That is a choice each household must make—it is a question of weighing the interest a bond fund strategy creates against the hassle and possible fees associated with the transfers it requires. Our example does not yield a clear-cut choice for any one household, but we can make some generalizations about its implications. First, a household is more likely to adopt a bond fund strategy when the interest rate is higher.

At low interest rates, a household does not sacrifice much income by pursuing the simpler cash strategy. As the interest rate rises, a bond fund strategy becomes more attractive. That means that the higher the interest rate, the lower the quantity of money demanded. Second, people are more likely to use a bond fund strategy when the cost of transferring funds is lower. The creation of savings plans, which began in the s and s, that allowed easy transfer of funds between interest-earning assets and checkable deposits tended to reduce the demand for money.

Some money deposits, such as savings accounts and money market deposit accounts, pay interest. In evaluating the choice between holding assets as some form of money or in other forms such as bonds, households will look at the differential between what those funds pay and what they could earn in the bond market.

A higher interest rate in the bond market is likely to increase this differential; a lower interest rate will reduce it. An increase in the spread between rates on money deposits and the interest rate in the bond market reduces the quantity of money demanded; a reduction in the spread increases the quantity of money demanded. Firms, too, must determine how to manage their earnings and expenditures. How is the speculative demand for money related to interest rates? When financial investors believe that the prices of bonds and other assets will fall, their speculative demand for money goes up.

The speculative demand for money thus depends on expectations about future changes in asset prices.

Will this demand also be affected by present interest rates? If interest rates are low, bond prices are high. It seems likely that if bond prices are high, financial investors will become concerned that bond prices might fall.

That suggests that high bond prices—low interest rates—would increase the quantity of money held for speculative purposes. Conversely, if bond prices are already relatively low, it is likely that fewer financial investors will expect them to fall still further.

They will hold smaller speculative balances. Economists thus expect that the quantity of money demanded for speculative reasons will vary negatively with the interest rate. The Demand Curve for Money We have seen that the transactions, precautionary, and speculative demands for money vary negatively with the interest rate. Putting those three sources of demand together, we can draw a demand curve for money to show how the interest rate affects the total quantity of money people hold.

The demand curve for money Curve that shows the quantity of money demanded at each interest rate, all other things unchanged. Such a curve is shown in Figure An increase in the interest rate reduces the quantity of money demanded. A reduction in the interest rate increases the quantity of money demanded. Its downward slope expresses the negative relationship between the quantity of money demanded and the interest rate.

The relationship between interest rates and the quantity of money demanded is an application of the law of demand. If we think of the alternative to holding money as holding bonds, then the interest rate—or the differential between the interest rate in the bond market and the interest paid on money deposits—represents the price of holding money.

As is the case with all goods and services, an increase in price reduces the quantity demanded. Other Determinants of the Demand for Money We draw the demand curve for money to show the quantity of money people will hold at each interest rate, all other determinants of money demand unchanged. Among the most important variables that can shift the demand for money are the level of income and real GDP, the price level, expectations, transfer costs, and preferences.

That relationship suggests that money is a normal good: An increase in real GDP increases incomes throughout the economy. The demand for money in the economy is therefore likely to be greater when real GDP is greater.

The Price Level The higher the price level, the more money is required to purchase a given quantity of goods and services.

bestwebdirectory.info - Money and Interest Rate Relationship

All other things unchanged, the higher the price level, the greater the demand for money. Expectations The speculative demand for money is based on expectations about bond prices. All other things unchanged, if people expect bond prices to fall, they will increase their demand for money.

If they expect bond prices to rise, they will reduce their demand for money. The expectation that bond prices are about to change actually causes bond prices to change. If people expect bond prices to fall, for example, they will sell their bonds, exchanging them for money. That will shift the supply curve for bonds to the right, thus lowering their price.

The importance of expectations in moving markets can lead to a self-fulfilling prophecy. Expectations about future price levels also affect the demand for money. The expectation of a higher price level means that people expect the money they are holding to fall in value. Given that expectation, they are likely to hold less of it in anticipation of a jump in prices. Expectations about future price levels play a particularly important role during periods of hyperinflation. If prices rise very rapidly and people expect them to continue rising, people are likely to try to reduce the amount of money they hold, knowing that it will fall in value as it sits in their wallets or their bank accounts.

Toward the end of the great German hyperinflation of the early s, prices were doubling as often as three times a day. Under those circumstances, people tried not to hold money even for a few minutes—within the space of eight hours money would lose half its value!

Transfer Costs For a given level of expenditures, reducing the quantity of money demanded requires more frequent transfers between nonmoney and money deposits. As the cost of such transfers rises, some consumers will choose to make fewer of them. They will therefore increase the quantity of money they demand. In general, the demand for money will increase as it becomes more expensive to transfer between money and nonmoney accounts. The demand for money will fall if transfer costs decline.

Now, once again this is the exact same logic we use with the demand and supply curve for any good or service. For money might look like this. Those first few dollars someone has a very low opportunity cost of lending it out, so, their willing to lend it out at a very low interest rate.

Then every incremental dollar after that theirs higher opportunity cost, and people will lend it out at a higher and higher rate.

money demand and interest rate relationship

Then you have a market equilibrium interest rate. Let me copy and paste this.

money demand and interest rate relationship

Then we could think about what happens in different scenarios. Now we have 2 scenarios that we can work on, and then let me just do 1 more. Let's think of a couple. Let's say that the central bank of our country, in the United States, that would be the Federal Reserve, the central bank prints more money. Then decides to lend out that money. It is disturbed when central banks print money. The way that it enters into circulation in most countries is that the central bank then goes and essentially lends that money.

The way it's done in the US Fed, most part they go out and buy government securities which is essentially lending money to the Federal Government. They do that because that's considered to be the safest investment. They go out there and they lend money.

If this is our original supply curve. If this is our original supply curve, but now your Federal Central Bank is printing more money and lending it out. What is going to happen over here? Your supply curve is going to shift to the right at any given price, at any given interest rate. Your going to have a larger quantity of money being available.

It might look something like Assuming that's the only change that happens you see its effect. Your new equilibrium price of money, the rent on money, or the interest rate on money is now lower. That's why when the Federal Reserves say I want to lower interest rates, they do so by printing money. They print that money, and they lend it out in the market. That essentially has the effect of lowering interest rates. Let's think about another situation.

Let's say this is the Fed prints and lends money.