Outline: Why agents wish to hold money. The portfolio choice The

Outline: Why agents wish to hold money. The portfolio choice The demand for money Bond prices and interest rates —why they move inversely Bearishness and bullishness in the money market The supply of money Equilibrium in the money market How the money market reaches equilibrium.

To make transactions To be prepared for contingencies— accidents, lawsuits, e.g. To store wealth—as an alternative to bonds, equities, jewelry, farmland, etc.

The Portfolio Decision: Money or Bonds? Bonds yield interest; money does not. The opportunity cost of holding money is given by the interest that could have been earned by holding bonds. “Interest is the reward for parting with liquidity.”

The Demand for Money (Md) d M f ( P, Y , r ) Where: Md is the total demand for money P is the price level Y is real income (or GDP) r is the rate of interest (or percentage yield of bonds).

Md is positively related to P and Y, ceteris paribus. Also, Md is inversely related to r, ceteris paribus.

Interest Rate 6% Demand for Money E As we move along Md, P and Y are held constant. The movement from point E to F is a change in the demand for money as a store of value in reaction to a decrease in the yield of bonds. F 3% Md 0 500 800 Money ( Billions)

Interest Rate Effect of a Change in Price Level (P) or Real GDP (Y) Md1 Md2 Increase in P, ceteris paribus. 6% E G Increase in Y, ceteris paribus H F 3% Md1 0 500 700 800 1,000 Md 2 Money ( Billions)

Bond Prices and the Rate Of Interest Bond prices and interest rates (or yields), move inversely

Suppose you paid 800 for a bond that promises to pay 1,000 to its holder one year from today. What is the interest rate or percentage yield of the bond? Notice first that your interest income would be equal to 200. Hence to compute the yield, use the following equation: Yield (%) (interest income/price of the bond) 100 Thus, we have: Yield (%) (200/800) 100 25 percent Now suppose, instead of paying 800 for the bond, you paid 900. What is the yield now? Yield (%) (100/900) 100 11 percent

To say the market is “bullish” is to say that, on average, people forecast that interest rates will decline; hence bond prices are heading up.

When people are bearish, they expect interest rates to rise, and bond prices to fall.

Bullishness means people want to hold less money as a store of value. Bullishness results in a decrease (shift to the left) of the Md function as people buy bonds in anticipation of rising prices.

Interest Effects of Market Bearishness Rate 6% E K F 3% Md2 Md1 0 500 800 Money ( Billions)

The supply of money schedule reveals the stock of money available to satisfy the demand for money at various interest rates. We assume the supply of money is determined by the Federal Reserve system or the Fed. The Fed can change the money supply by adjusting reserve requirements, the discount rate, or by open market operations.

Interest Rate Supply of Money (Ms) Ms1 Ms2 M s1 M s2 Decrease of RRR 6% 3% 0 E Decrease of discount rate J Open market purchase of government securities 500 700 Money ( Billions)

Interest Rate 7% 6% Equilibrium in the Money market Ms When r 7%, Ms Md by 85 billion. When r 3%, Md Ms by 300 billion. E When r 6%, Ms Md 3% Md 0 415 500 800 Money ( Billions)

When there is an excess supply of money in the economy, there is also an excess demand for bonds Interest rate higher than equilibrium Excess supply of money Excess demand for bonds Public buys bonds Price of bonds rises