Opportunity Cost of Holding Money

  • The decision to hold onto cash has an opportunity cost. It's money that can't be used to invest in other assets

  • In June 2007, the federal funds rate was 5.25%

  • In June 2008, the federal funds rate dropped to 2.00%

  • In June 2009, the federal funds rate set to 0.0 - 0.25%

  • Interest rate you get on cash is 0.0%

  • The opportunity of cost of money has decreased over that two-year time span

The Money Demand Curve

Interest rate, r Money demand curve, MD Quantity of money

Shifts of the Money Demand Curve

Interest rate, r rl A fall in money demand shifts the money demand
  curve to the left. IL M1—-M2 A rise in money demand shifts the money
  demand curve to the right. MD3 MDI Quantity of money

  • Changes in the Aggregate Price Level

    • Higher prices have led to an increase in the demand for money

    • Demand for money is proportional to the price level.

    • If prices rise by 10%, demand increases by the same amount

  • Changes in Real GDP

    • As real GDP increases, the larger quantity of money that households and firms will hold
  • Changes in Technology

    • Availability of ATMs and widespread acceptance of credit purchases decreases money demand
  • Changes in Institutions

    • Regulation Q barred interest-bearing checking.

    • When eliminated in 1980, MD shifted to the right

Money and Interest Rates

  • The Federal Open Market Committee (FOMC) is in charge of setting the target federal funds rate

    • The Federal Reserve doesn't actually set the federal funds rate by fiat

    • The Open Market Desk at the New York Fed buys (or sells) bonds in order to achieve the target

  • When the Fed lowers the federal funds rate, other short-term interest rates (CD rates) fall in a corresponding matter

  • In an era of a 0% federal funds rate, the opportunity cost of holding onto money is about as low as you can get

Liquidity Preference Model

  • Liquidity Preference Model of the Interest Rate

    • Interest rate in money market is determined by the supply and demand for money

    • Combine the MD, which is downward sloping with the MS, which is the quantity of money supplied by the Federal Reserve

  • The Fed can either increase or decrease the money supply using one of its three monetary policy tools

    • Open Market Operations

    • Changing Reserve Requirements

    • Lending through the Discount Window

Discount Rate Raise Lower Reserve Requirement Raise Lower Open Market
Operations Buying Selling Effect Less money More money Effect Less money
More money Effect More money Less money Reason Banks borrow less money
because Of higher interest. Banks have more money in reserves. Reason
Banks are required to keep more and lend less to borrowers. Banks keep
less in vaults and lend more to borrowers. Reason The Fed gives money to
banks in exchange for bonds. The Fed takes money from banks in exchange
for bonds.

  • Equilibrium in the Money Market

    Interest rate, r Equilibrium interest rate 4 Money supply curve, MS
Equilibrium Money supply chosen by the Fed MD Quantity of money

    Machine generated alternative text: MSO 9 0 M52 Decrease in money
supply \] 5e5 rate Increase in money supply lowers 《 nterest rate M51
MD Real money (trillions of 2 佣 5 dollars)

Practice Questions

  • Which of the following will decrease the demand for money?

    a. An increase in interest rates

    b. A rising level of inflation

    c. An increase in GDP

    d. An increase in the availability of ATMs

    e. A decrease in interest rates

    Answer: d

    Option a is change the quantity demanded, not the demand itself

  • If the Fed sells Treasury securities, what happens to the money supply and the equilibrium interest rate? Graph your response

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  • If the Fed buys Treasury securities, what happens to the money supply and the equilibrium interest rate? Graph your response

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