MODULE 28 and 29 Notes
OPPORTUNITY COST OF HOLDING MONEY
• What is the O.C of holding money?
- You gain the convenience of being able to spend it easily
- You lose the ability to earn interest on it.
• The higher the short-term interest rate, the higher the opportunity cost of holding money. The lower the short-term interest, the lower the opportunity cost.
• Since we Demand money to make purchases in the short term, the opportunity cost of holding money is the short-term interest rate.
• We assume that in a short period of time, there will be virtually no inflation, so the nominal interest rate is equal to the real interest rate
• When the interest rate rises, the opportunity cost of holding money rises, so the quantity of money demanded will fall
• The money demand curve is downward sloping.
SHIFTS OF THE MONEY DEMAND CURVE
• Just like there are external factors that shift the demand curve for pomegranates, there are external factors that shift the demand for money
• The most important factors causing the money demand curve to shift are changes in the aggregate demand curve to shift are changes in REAL GDP, changes in Banking Technology and banking institutions.
CHANGES IN AGGREGATE PRICE LEVEL
• All else equal, higher prices will increase the demand for money (A rightward shift in the MD curve) and lower prices reduces the demand for money (A leftward shift of the MD Curve)
• We can actually be more specific than this: other things equal, the demand for money is proportional to the price level. That is, if the aggregate price level rises by 20% the quantity of money demanded at any given interest rate also rises by 20%
• Why? Because if the price of everything rise by 20% that it takes 20% more money to buy the same basket of goods and serves.
CHANGES IN REAL GDP
• As the economy gets stronger, real incomes and Real GDP Rise.
• The larger the quantity of goods and services we buy, the larger the quantity of money we will want to hold at any given interest rate.
• So an increase in real GDP--The total quantity of goods and services produced and sold in the economy--shifts the money demand curve downward
CHANGES IN TECHNOLOGY
• Changes in technology can affect the demand for money.
• In general, advances in information technology have tended to reduce the demand for money by making it easier for the public to make purchases without holding significant sums for money.
• If there was an ATM machine on every corner in every retail store and restaurant, there would be little need to hold money in your pocket.
CHANGES IN INSTITUTIONS
• Regulations that make it more attractive to keep money in banks will reduce the demand for money.
• If a nation's political and banking systems became dangerously unstable, it might increase the demand for money because people would rather hoard their money than store it in institutions that might be falling apart.
• The model of liquidity preference describes equilibrium in the money market. This model is a good foundation for learning a similar market in loanable funds that is also useful in describing how interest rates are determined and the impact of monetary policy
MODULE 29
MARKET FOR LOANABLE FUNDS
• It is through the financial markets by which the funds of the savers are borrowed by investors
• Economists use the model of a market for loanable funds to explain these interactions and determine the equilibrium real interest rate.
EQUILIBRIUM INTEREST RATE
• Economists work with a simplified model in which there is only one market where there is just one market which brings together those who want to lend money (savers) and those who want to borrow (Firms with investment spending projects)
• The hypothetical market is known as the loanable funds market. The price that is determined in the loanable funds market is the interest rate, denoted by 'r'.
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