Principles of Microeconomics Chapter 10 Financial Markets and the Economy

Chapter 10 Financial Markets and the Economy Start Up Clamping Down on Money Growth For nearly three decades , Americans have come to expect very low inflation , on the order of to a year . How did this expectation come to be ?

Was it always so ?

Absolutely not . In July 1979 , with inflation approaching 14 and interest rates on Treasury bills soaring past 10 , a desperate President Jimmy Carter took action . He appointed Paul , the president of the New York Federal Reserve Bank , as chairman of the Fed Board of Governors . made clear that his objective as chairman was to bring down the inflation matter what the consequences for the economy . Carter gave this effort his full support . wasted no time in putting his policies to work . He slowed the rate of money growth immediately . The economy response was swift the United States slipped into a brief recession in 1980 , followed by a crushing recession in . In terms of the goal of reducing inflation , monetary policies were a dazzling success . Inflation plunged below a rate within three years by 1986 the inflation rate had fallen to . The tall , bald , emerged as a folk hero in the fight against . Indeed he has returned 20 years later as part of President Obama economic team to perhaps once again rescue the economy . The Fed fight against inflation from 1979 to 1986 made the job for Alan , successor , that much easier . To see how the decisions of the Federal Reserve affect key , the price level , and this chapter we will explore how financial markets , markets in which funds accumulated by one group are made available to another group , are linked to the economy . This chapter provides the building blocks for understanding financial markets . Beginning with an overview of bond and foreign exchange markets , we will examine how they are related to the level of real and the price level . The second section completes the model of the money market . We have learned that the Fed can change the amount of reserves in the banking system , and that when it does the money supply changes . Here we explain money quantity of money people and firms want to , together with money supply , leads to an equilibrium rate of interest . The model of aggregate demand and supply shows how changes in the components of aggregate demand affect and the price level . In this chapter , we will learn that changes in the financial markets can affect aggregate in turn can lead to changes in real and the price level . Showing how the financial markets fit into the model of aggregate demand and aggregate supply we developed earlier provides a more complete picture of how the works . 333

The Bond and Foreign Exchange Markets Learning Objectives . Explain and illustrate how the bond market works and discuss the relationship between the price of a bond and that bond interest rate . Explain and illustrate the relationship between a change in demand for or supply of bonds and activity . Explain and illustrate how the foreign exchange market works and how a change in demand for a country currency or a change in its supply affects activity . In this section , we will look at the bond market and at the market for foreign exchange . Events in these markets can affect the price level and output for the entire economy . The Bond Market In their daily operations and in pursuit of new projects , institutions such as firms and governments often borrow . They may seek funds from a bank . Many institutions , however , obtain credit by selling bonds . The federal government is one institution that issues bonds . A local school district might sell bonds to finance the construction of a new school . Your college or university has probably sold bonds to finance new buildings on campus . Firms often sell bonds to finance expansion . The market for bonds is an enormously important one . When an institution sells a bond , it obtains the price paid for the bond as a kind of loan . The institution that issues the bond is obligated to make payments on the bond in the future . The interest rate is determined by the price of the bond . To understand these relationships , let us look more closely at bond prices and interest rates . Bond Prices and Interest Rates Suppose the manager of a manufacturing company needs to borrow some money to expand the factory . The manager could do so in the following way he or she prints , say , 500 pieces of paper , each bearing the company promise to pay the bearer in a year . These pieces of paper are bonds , and the company , as the issuer , promises to make a single payment . The manager then offers these bonds for sale , announcing that they will be sold to the buyers who offer the highest prices . Suppose the highest 334

335 Author removed at request of original publisher price offered is 950 , and all the bonds are sold at that price . Each bond is , in effect , an obligation to repay buyers . The buyers of the bonds are being paid 50 for the service of lending 950 for a yean The printed on each bond is the face value of the bond it is the amount the issuer will have to pay on the maturity date of the date when the loan matures , or comes due . The 950 at which they were sold is their price . The difference between the face value and the price is the amount paid for the use of the money obtained from selling the bond . An interest rate is the payment made for the use of money , expressed as a percentage of the amount borrowed . Bonds you sold command an interest rate equal to the difference between the face value and the bond price , divided by the bond price , and then multiplied by 100 to form a percentage Equation Face value bond price , 100 rate Bond At a price of 950 , the interest rate is , 000 950 100 950 The interest rate on any bond is determined by its price . As the price falls , the interest rate rises . Suppose , for example , that the best price the manager can get for the bonds is 900 . Now the interest rate is . A price of 800 would mean an interest rate of 25 750 would mean an interest rate of a price of 500 translates into an interest rate of 100 . The lower the price of a bond relative to its face value , the higher the interest rate . Bonds in the real world are more complicated than the piece of paper in our example , but their structure is basically the same . They have a face value ( usually an amount between and ) and a maturity date . The maturity date might be three months from the date of issue it might be 30 years . Whatever the period until it matures , and whatever the face value of the bond may be , its issuer will attempt to sell the bond at the highest possible price . Buyers of bonds will seek the lowest prices they can obtain . Newly issued bonds are generally sold in auctions . Potential buyers bid for the bonds , which are sold to the highest bidders . The lower the price of the bond relative to its face value , the higher the interest rate . Both private firms and government entities issue bonds as a way of raising funds . The original buyer need not hold the bond until maturity . Bonds can be resold at any time , but the price the bond will fetch at the time of resale will vary depending on conditions in the economy and the financial markets . Figure The Bond Market illustrates the market for bonds . Their price is determined by demand

Principles of 336 and supply . Buyers of newly issued bonds are , in effect , lenders . Sellers of newly issued bonds are that corporations , the federal government , and other institutions sell bonds when they want to borrow money . Once a newly issued bond has been sold , its owner can resell it a bond may change hands several times before it matures . The Bond Market 950 ( Price of bonds ( with implied interest rate ) Quantity of bonds per period THE equilibrium price bonds IS where me demand and supply curves ( The here 15 a of 950 . implying an rate of . An increase In . all other equal , increases me supply of bonds to and forces me or hands down In 900 . The interest rate rises to . Bonds are not exactly the same sort of product as , say , broccoli or some other good or service . Can we expect bonds to have the same kind of demand curves and supply curves we encounter for ordinary goods and services ?

Yes . Consider demand . At lower prices , bonds pay higher interest . That makes them more attractive to buyers of bonds and thus increases the quantity demanded . On the other hand , lower prices mean higher costs to of should reduce the quantity supplied . Thus , the negative relationship between price and quantity demanded and the positive relationship between price and quantity supplied suggested by conventional demand and supply curves holds true in the market for bonds . If the quantity of bonds demanded is not equal to the quantity of bonds supplied , the price will adjust almost instantaneously to balance the two . Bond prices are perfectly flexible in that they change immediately to balance demand and supply . Suppose , for example , that the initial price of bonds is 950 , as shown by the intersection of the demand and supply curves in Figure The Bond Market . We

337 Author removed at request of original publisher will assume that all bonds have equal risk and a face value of and that they mature in one year . Now suppose that borrowers increase their borrowing by offering to sell more bonds at every interest rate . This increases the supply of bonds the supply curve shifts to the right from to . That , in turn , lowers the equilibrium price of 900 in Figure The Bond Market . The lower price for bonds means a higher interest rate . The Bond Market and Performance The connection between the bond market and the economy derives from the way interest rates affect aggregate demand . For example , investment is one component of aggregate demand , and interest rates affect investment . Firms are less likely to acquire new capital ( that is , plant and equipment ) if interest rates are high they re more likely to add capital if interest rates are low . If bond prices fall , interest rates go up . Higher interest rates tend to discourage investment , so aggregate demand will fall . A fall in aggregate demand , other things unchanged , will mean fewer jobs and less total output than would have been the case with lower rates of interest . In contrast , an increase in the price of bonds lowers interest rates and makes investment in new capital more attractive . That change may boost investment and thus boost aggregate demand . Figure Bond Prices and Activity shows how an event in the bond market can stimulate changes in the economy output and price level . In Panel ( a ) an increase in demand for bonds raises bond prices . Interest rates thus fall . Lower interest rates increase the quantity of investment demanded , shifting the aggregate demand curve to the right , from to in Panel ( Real rises from to the price level rises from to . In Panel ( an increase in the supply of bonds pushes bond prices down . Interest rates rise . The quantity of investment is likely to fall , shifting aggregate demand to the left , from to AD in Panel ( Output and the price level fall from to and from to , respectively . Assuming other of aggregate demand remain unchanged , higher interest rates will tend to reduce aggregate demand and lower interest rates will tend to increase aggregate demand . Bond and . Consumption may also be affected by changes in interest rates . For example , if interest rates fall , consumers can more easily obtain credit and thus are more likely to purchase cars and other durable goods . To simplify , we ignore this effect .

Principles of 338 Panel ( a ) Panel ( When bond prices go up real and the price level rise . III 02 Quantity of bonds per period Real per year Panel ( Panel ( When bond prices fall real and the price level may fall . a . 02 Quantity of bonds per period Real per year An in the demand for bonds in Panel ( a ) the of bonds ) which and boosts investment . demand AD in Panel ( ii ) teal and die El . An increase in the supply of bonds to lowers bond prices to in Panel ( and raises interest rates . The higher interest rate , taken by itself , is likely to cause a reduction in investment and aggregate demand . falls to , real falls to , and the price level falls to in Panel ( In thinking about the impact of changes in interest rates on aggregate demand , we must remember that some events that change aggregate demand can affect interest rates . We will examine those events in subsequent chapters . Our focus in this chapter is on the way in which events that originate in financial markets affect aggregate demand . Foreign Exchange Markets Another financial market that influences variables is the foreign exchange market , a market in which currencies of different countries are traded for one another . Since changes in exports and

339 Author removed at request of original publisher imports affect aggregate demand and thus real and the price level , the market in which currencies are traded has tremendous importance in the economy . Foreigners who want to purchase goods and services or assets in the United States must typically pay for them with dollars . United States purchasers of foreign goods must generally make the purchase in a foreign currency . An Egyptian family , for example , exchanges Egyptian pounds for dollars in order to pay for admission to Disney World . A German financial investor purchases dollars to buy government bonds . A family from the United States visiting India , on the other hand , needs to obtain Indian rupees in order to make purchases there . A bank wanting to purchase assets in Mexico City first purchases pesos . These transactions are accomplished in the foreign exchange market . The foreign exchange market is not a single location in which currencies are traded . The term refers instead to the entire array of institutions through which people buy and sell currencies . It includes a hotel desk clerk who provides currency exchange as a service to hotel guests , brokers who arrange currency exchanges worth billions of dollars , and governments and central banks that exchange currencies . Major currency dealers are linked by computers so that they can track currency exchanges all over the world . The Exchange Rate A country exchange rate is the price of its currency in terms of another currency or currencies . On December 12 , 2008 , for example , the dollar traded for Japanese yen , euros , South African , and Mexican pesos . There are as many exchange rates for the dollar as there are countries whose currencies exchange for the 200 of them . Economists summarize the movement of exchange rates with a exchange rate , which is an index of exchange rates . To calculate a exchange rate index for the dollar , we select a group of countries , weight the price of the dollar in each country currency by the amount of trade between that country and the United States , and then report the price of the dollar based on that average . Because exchange rates are so widely used in reporting currency values , they are often referred to as exchange rates themselves . We will follow that convention in this text . Determining Exchange Rates The rates at which most currencies exchange for one another are determined by demand and supply . How does the model of demand and supply operate in the foreign exchange market ?

The demand curve for dollars relates the number of dollars buyers want to buy in any period to the exchange rate . An increase in the exchange rate means it takes more foreign currency to buy a dollar . A higher exchange rate , in turn , makes goods and services more expensive for foreign buyers and reduces the quantity they will demand . That is likely to reduce the quantity of dollars they demand . Foreigners thus will demand fewer dollars as the price of the exchange .

Principles of 340 Consequently , the demand curve for dollars is downward sloping , as in Figure Determining an Exchange Rate . Determining an Exchange Rate Exchange rate Quantity of dollars per period The equilibrium exchange rate the rate at winch the quantity of demanded equals the supplied . Here . equilibrium al exchange rate , at which dollars are exchanged per period . The supply curve for dollars emerges from a similar process . When people and firms in the United States purchase goods , services , or assets in foreign countries , they must purchase the currency of those countries first . They supply dollars in exchange for foreign currency . The supply of dollars on the foreign exchange market thus reflects the degree to which people in the United States are buying foreign money at various exchange rates . A higher exchange rate means that a dollar trades for more foreign currency . In effect , the higher rate makes foreign goods and services cheaper to buyers , so consumers will purchase more foreign goods and services . People will thus supply more dollars at a higher exchange rate we expect the supply curve for dollars to be upward sloping , as suggested in Figure Determining an Exchange Rate . In addition to private individuals and firms that participate in the foreign exchange market , most governments participate as well . A government might seek to lower its exchange rate by selling its

341 Author removed at request of original publisher currency it might seek to raise the rate by buying its currency . Although governments often participate in foreign exchange markets , they generally represent a very small share of these markets . The most important traders are private buyers and sellers of currencies . Exchange Rates and Performance People purchase a country currency for two quite different reasons to purchase goods or services in that country , or to purchase the assets of that money , its capital , its stocks , its bonds , or its real estate . Both of these motives must be considered to understand why demand and supply in the foreign exchange market may change . One thing that can cause the price of the dollar to rise , for example , is a reduction in bond prices in American markets . Figure Shifts in Demand and Supply for Dollars on the Foreign Exchange Market illustrates the effect of this change . Suppose the supply of bonds in the bond market increases from to in Panel ( a ) Bond prices will drop . Lower bond prices mean higher interest rates . Foreign financial investors , attracted by the opportunity to earn higher returns in the United States , will increase their demand for dollars on the foreign exchange market in order to purchase bonds . Panel ( shows that the demand curve for dollars shifts from to . Simultaneously , financial investors , attracted by the higher interest rates at home , become less likely to make financial investments abroad and thus supply fewer dollars to exchange markets . The fall in the price of bonds shifts the supply curve for dollars on the foreign exchange market from to , and the exchange rate rises from to . Figure Shifts Demand and Supply Dollars an the Exchange Market Panel ( a ) Panel ( Panel ( Bond Market Foreign Exchange Market AD Price of bonds Exchange rate Price level 0102 Quantity of bonds per period Quantity of dollars per period Real per year In Panel ( a ) an increase the supply of bonds lowers bond prices ( and raises interest rates ) interest rates boost the demand and reduce the supply for dollars . me exchange me Panel an to . These developments me band and exchange markets are likely a net exports and In , aggregate demand from Am AD Panel ( The level me economy falls and real falls from Yr Io . The higher exchange rate makes goods and services more expensive to foreigners , so it reduces exports . It makes foreign goods cheaper for buyers , so it increases imports . Net exports thus fall , reducing aggregate demand . Panel ( shows that output falls from to the price level falls from to . This development in the foreign exchange market reinforces the impact of higher interest rates we

Principles of 342 observed in Figure Bond Prices and Activity , Panels ( and ( They not only reduce reduce net exports as well . Key Ta A bond represents a debt bond prices are determined by demand and supply . The interest rate on a bond is negatively related to the price of the bond . As the price of a bond increases , the interest rate falls . An increase in the interest rate tends to decrease the quantity of investment demanded and , hence , to decrease aggregate demand . A decrease in the interest rate increases the quantity of investment demanded and aggregate demand . The demand for dollars on foreign exchange markets represents foreign demand for goods , services , and assets . The supply of dollars on foreign exchange markets represents demand for foreign goods , services , and assets . The demand for and the supply of dollars determine the exchange rate . A rise in interest rates will increase the demand for dollars and decrease the supply of dollars on foreign exchange markets . As a result , the exchange rate will increase and aggregate demand will decrease . A fall in interest rates will have the opposite effect . Suppose the supply of bonds in the market decreases . Show and explain the effects on the bond and foreign exchange markets . Use the aggregate supply framework to show and explain the effects on investment , net exports , real , and the price level . Case in Point Bill Gross Mea Culpa

343 Author removed at request of original publisher ' nu on um in nu On ma . US Treasury Bond Illustration BY . In October 2011 , bond fund manager Bill Gross sent out an extraordinary open letter titled Mea He was taking the blame for the poor performance of Total Return Bond Fund , the huge fund he manages . After years of stellar performance , what had gone wrong ?

Earlier in 2011 , Gross announced that he would avoid US . Treasury bonds . He assumed that as the and other countries economies recovered , interest rates would begin to rise and , hence , bond prices would fall . When . Gross pulled out of Treasuries , he used some of the cash to buy other types of debt , such as that of emerging markets . He also held onto some cash . He warned others to shun Treasuries as well . However , as the financial situation in Europe weakened over worries about government debt in various European with Greece and then spilling over to Portugal , Spain , Italy , and around the world flocked toward Treasuries , pushing Treasury bond prices up . It was a rally that Gross customers missed . From where did the financial investors get the funds to buy Treasuries ?

In part , these funds were obtained from some of the same types of bonds that were then in the fund portfolio . As a result , the prices of bonds in the fund fell . In the letter , Gross wrote , The simple fact is that the portfolio at midyear was positioned for what we call a New Normal developed world real growth and . When growth estimates quickly changed it was obvious that I had misjudged the ball or for In the fall of 2011 , he shifted gears and began buying Treasuries , assuming that a weak global economy would keep interest rates low . He was foiled again , as interest rates started to rise a bit . In the end , 2011 turned out to be a bad year for the fund , ranking poorly compared to its peers . But after many successful years , it retained its rating by in 2012 . We must wait to see whether . Gross will get his groove back . In the letter , he concluded , There is no quit in me or anyone else on the premises . The early morning and even midnight hours have gone up , not down , to match the increasing complexity of the global financial markets . The competitive fire burns even hotter . respect our competition but we want to squash them each and every day Source Bill Gross Apologizes to Fund Owners for Bad Year , Los Angeles Times , October 14 , 2011 , online version .

Principles of 344 Answer to Try It ! Problem If the supply of bonds decreases from to , bond prices will rise from to , as shown in Panel ( a ) Higher bond prices mean lower interest rates . Lower interest rates in the United States will make financial investments in the United States less attractive to foreigners . As a result , their demand for dollars will decrease from to , as shown in Panel ( Similarly , US . financial investors will look abroad for higher returns and thus supply more dollars to foreign exchange markets , shifting the supply curve from to . Thus , the exchange rate will decrease . The quantity of investment rises due to the lower interest rates . Net exports rise because the lower exchange rate makes goods and services more attractive to foreigners , thus increasing exports , and makes foreign goods less attractive to US . buyers , thus reducing imports . Increases in investment and net exports imply a rightward shift in the aggregate demand curve from to . Real and the price level increase . Panel ( a ) Panel ( Panel ( Price of bonds Exchange rate Price level . I I , Quantity of bonds per period Quantity per period Real

Demand , Supply , and Equilibrium in the Money Market Learning Objectives . Explain the motives for holding money and relate them to the interest rate that could be earned from holding alternative assets , such as bonds . Draw a money demand curve and explain how changes in other variables may lead to shifts in the money demand curve . Illustrate and explain the notion of equilibrium in the money market . Use graphs to explain how changes in money demand or money supply are related to changes in the bond market , in interest rates , in aggregate demand , and in real and the price level . In this section we will explore the link between money markets , bond markets , and interest rates . We first look at the demand for money . The demand curve for money is derived like any other demand curve , by examining the relationship between the price of money ( which , we will see , is the interest rate ) and the quantity demanded , holding all other unchanged . We then link the demand for money to the concept of money supply developed in the last chapter , to determine the equilibrium rate of interest . In turn , we show how changes in interest rates affect the . The Demand for Money In deciding how much money to hold , people make a choice about how to hold their wealth . How much wealth shall be held as money and how much as other assets ?

For a given amount of wealth , the answer to this question will depend on the relative costs and benefits of holding money versus other assets . The demand for money is the relationship between the quantity of money people want to hold and the factors that determine that quantity . To simplify our analysis , we will assume there are only two ways to hold wealth as money in a checking account , or as funds in a bond market mutual fund that purchases bonds on behalf of its subscribers . A bond fund is not money . Some money deposits earn interest , but the return on these accounts is generally lower than what could be obtained in a bond fund . The advantage of checking accounts is that they are highly liquid and can thus be spent easily . We will think of the demand for money as a curve that represents the outcomes of choices between the greater liquidity of money deposits and the higher interest rates that can be earned by holding a bond fund . The difference between the interest rates paid on money deposits and the interest return available from bonds is the cost of holding money . 345

Principles of 346 Motives for Holding Money One reason people hold their assets as money is so that they can purchase goods and services . The money held for the purchase of goods and services may be for everyday transactions such as buying groceries or paying the rent , or it may be kept on hand for contingencies such as having the funds available to pay to have the car fixed or to pay for a trip to the doctor . The transactions demand for money is money people hold to pay for goods and services they anticipate buying . When you carry money in your purse or wallet to buy a movie ticket or maintain a checking account balance so you can purchase groceries later in the month , you are holding the money as part of your transactions demand for money . The money people hold for contingencies represents their precautionary demand for money . Money held for precautionary purposes may include checking account balances kept for possible home repairs or needs . People do not know precisely when the need for such expenditures will occur , but they can prepare for them by holding money so that they have it available when the need arises . People also hold money for speculative purposes . Bond prices fluctuate constantly . As a result , holders of bonds not only earn interest but experience gains or losses in the value of their assets . enjoy gains when bond prices rise and suffer losses when bond prices fall . Because of this , expectations play an important role as a determinant of the demand for bonds . Holding bonds is one alternative to holding money , so these same expectations can affect the demand for money . John Maynard Keynes , who was an enormously successful speculator in bond markets himself , suggested that who anticipate a drop in bond prices will try to sell their bonds ahead of the price drop in order to avoid this loss in asset value . Selling a bond means converting it to money . Keynes referred to the speculative demand for money as the money held in response to concern that bond prices and the prices of other financial assets might change . Of course , money is money . One can not sort through someone checking account and locate which funds are held for transactions and which funds are there because the owner of the account is worried about a drop in bond prices or is taking a precaution . We distinguish money held for different motives in order to understand how the quantity of money demanded will be affected by a key determinant of the demand for money the interest rate . Interest Rates and the Demand for Money The quantity of money people hold to pay for transactions and to satisfy precautionary and speculative demand is likely to vary with the interest rates they can earn from alternative assets such as bonds . When interest rates rise relative to the rates that can be earned on money deposits , people hold less money . When interest rates fall , people hold more money . The logic of these conclusions about the money people hold and interest rates depends on the people motives for holding money . The quantity of money households want to hold varies according to their income and the interest rate

347 Author removed at request of original publisher different average quantities of money held can satisfy their transactions and precautionary demands for money . To see why , suppose a household earns and spends per month . It spends an equal amount of money each day . For a month with 30 days , that is 100 per 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 . The household would thus have in the checking account when the month begins , at the end of the first day , halfway through the month , and zero at the end of the last day of the month . Averaging the daily balances , we find that the quantity of money the household demands equals . This approach to money management , which we will call the cash approach , has the virtue of simplicity , but the household will earn no interest on its funds . Consider an alternative money management approach that permits the same pattern of spending . At the beginning of the month , the household deposits in its checking account and the other in a bond fund . Assume the bond fund pays interest per month , or an annual interest rate of . After 10 days , the money in the checking account is exhausted , and the household withdraws another from the bond fund for the next 10 days . On the day , the final from the bond fund goes into the checking account . With this strategy , the household has an average daily balance of 500 , which is the quantity of money it demands . Let us call this money management strategy the bond fund Remember that both approaches allow the household to spend per month , 100 per day . The cash approach requires a quantity of money demanded of , while the bond fund approach lowers this quantity to 500 . The bond fund approach generates some interest income . The household has in the fund for 10 days ( of a month ) and for 20 days ( of a month ) With an interest rate of per month , the household earns 10 in interest each month ( The disadvantage of the bond fund , of course , is that it requires more must be transferred from the fund twice each month . 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 begin each month with in the checking account and in the bond fund , transferring to the checking account midway through the month . This strategy requires one less transfer , but it also generates less ( With this strategy , the household demands a quantity of money of 750 . 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 asset as a bond fund strategy . Which approach should the household use ?

That is a choice each household must 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 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 .

Principles of 348 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 and 19805 , that allowed easy transfer of funds between 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 . However , instead of worrying about per month , even a relatively small firm may be concerned about per month . Rather than facing the difference of 10 versus in interest earnings used in our household example , this small firm would face a difference of per month ( versus ) For very large firms such as or AT , interest rate differentials among various forms of holding their financial assets translate into millions of dollars per day . 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 interest 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 shows the quantity of money demanded at each interest rate , all other things unchanged . Such a curve is shown in Figure The Demand Curve for Money . An increase in the interest rate reduces the quantity of money demanded . A reduction in the interest rate increases the quantity of money demanded . The Demand for Money

349 Author removed at request of original publisher Money demand Interest rate Quantity of money per period The demand curve for money Shows the quantity money demanded at each . downward slope expresses me negative relationship between me quantity of money demanded and me interest me . 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 the differential between the interest rate in the bond market and the interest paid on money the price of holding money . As is the case with all goods and services , an increase in price reduces the quantity demanded . Other 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 of money demand unchanged . A change in those other will shift the demand for money . Among the most important variables that can shift the demand for money are the level of income and real , the price level , expectations , transfer costs , and preferences .

Principles of 350 Real A household with an income of per month is likely to demand a larger quantity of money than a household with an income of per month . That relationship suggests that money is a normal good as income increases , people demand more money at each interest rate , and as income falls , they demand less . An increase in real increases incomes throughout the economy . The demand for money in the economy is therefore likely to be greater when real is greater . The Price Level The higher the price level , the more money is required to purchase a given quantity of goods and services . 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 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 , prices were doubling as often as three times a day . Under those circumstances , people tried not to hold money even for a few the space of eight hours money would lose half its value !

351 Author removed at request of original publisher Transfer Costs For a given level of expenditures , reducing the quantity of money demanded requires more frequent transfers between 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 accounts . The demand for money will fall if transfer costs decline . In recent years , transfer costs have fallen , leading to a decrease in money demand . Preferences Preferences also play a role in determining the demand for money . Some people place a high value on having a considerable amount of money on hand . For others , this may not be important . Household attitudes toward risk are another aspect of preferences that affect money demand . As we have seen , bonds pay higher interest rates than money deposits , but holding bonds entails a risk that bond prices might fall . There is also a chance that the issuer of a bond will default , that is , will not pay the amount specified on the bond to indeed , bond may end up paying nothing at all . A money deposit , such as a savings deposit , might earn a lower yield , but it is a safe yield . People attitudes about the between risk and yields affect the degree to which they hold their wealth as money . Heightened concerns about risk in the last half of 2008 led many households to increase their demand for money . Figure An Increase in Money Demand shows an increase in the demand for money . Such an increase could result from a higher real , a higher price level , a change in expectations , an increase in transfer costs , or a change in preferences . Figure An Increase in Money Demand

Principles of 352 Interest rate Quantity of money per period An increase in real , the price level , or transfer costs , for example , will increase the quantity of money demanded at any interest rate , increasing the demand for money from to . The of money demanded at interest rate rises from to . The reverse of any such events would reduce the quantity of money demanded at every interest rate , shifting the demand curve to the left . The Supply of Money The supply curve of money shows the relationship between the quantity of money supplied and the market interest rate , all other of supply unchanged . We have learned that the Fed , through its operations , determines the total quantity of reserves in the banking system . We shall assume that banks increase the money supply in fixed proportion to their reserves . Because the quantity of reserves is determined by Federal Reserve policy , we draw the supply curve of money in Figure The Supply Curve of Money as a vertical line , determined by the Fed monetary policies . In drawing the supply curve of money as a vertical line , we are assuming the money supply does not depend on the interest rate . Changing the quantity of reserves and hence the money supply is an example of monetary policy .

353 Author removed at request of original publisher Figure The Supply Curve of Money Money supply Interest rate Quantity of money per period We assume that the quantity of money supplied in the economy is determined as a fixed multiple of the quantity of bank reserves , which is determined by the Fed . The supply curve of money is a Vertical line at that quantity . Equilibrium in the Market for Money The money market is the interaction among institutions through which money is supplied to individuals , firms , and other institutions that demand money . Money market equilibrium occurs at the interest rate at which the quantity of money demanded is equal to the quantity of money supplied . Figure Money Market Equilibrium combines demand and supply curves for money to illustrate equilibrium in the market for money . With a stock of money ( the equilibrium interest rate is Figure Money Market Equilibrium

Principles of 354 Interest rate Quantity of money per period The market for money is in equilibrium if the quantity of money demanded is equal to the quantity of money supplied . Here , equilibrium occurs at interest rate Effects of Changes in the Money Market A shift in money demand or supply will lead to a change in the equilibrium interest rate . Let look at the effects of such changes on the economy . Changes in Money Demand Suppose that the money market is initially in equilibrium at with supply curve and a demand curve as shown in Panel ( a ) of Figure A Decrease in the Demand for Money . Now suppose that there is a decrease in money demand , all other things unchanged . A decrease in money demand could result from a decrease in the cost of transferring between money and deposits , from a change

355 Author removed at request of original publisher in expectations , or from a change in Panel ( a ) shows that the money demand curve shifts to the left to . We can see that the interest rate will fall to . To see why the interest rate falls , we recall that if people want to hold less money , then they will want to hold more bonds . Thus , Panel ( shows that the demand for bonds increases . The higher price of bonds means lower interest rates lower interest rates restore equilibrium in the money market . Figure A Decrease In the Demand ( or Money Panel ( a ) Panel ( Panel ( Interest rate ( percent ) Price of bonds Price level , Quantity per period Quantity or bonds per period Real sop per A decrease in me demand in . money due to change in transactions costs . preferences , or expectations . as shown in Panel ( will be accompanied by an Increase the demand in . as shown in Panel ( in ) and a fall the interest rate . The ran in the interest rate will cause a rightward in the aggregate demand AD to Ana . as shown HI Panel ( As a , real cup and the level . Lower interest rates in turn increase the quantity of investment . They also stimulate net exports , as lower interest rates lead to a lower exchange rate . The aggregate demand curve shifts to the right as shown in Panel ( from to . Given the aggregate supply curve , the economy moves to a higher real and a higher price level . An increase in money demand due to a change in expectations , preferences , or transactions costs that make people want to hold more money at each interest rate will have the opposite effect . The money demand curve will shift to the right and the demand for bonds will shift to the left . The resulting higher interest rate will lead to a lower quantity of investment . Also , higher interest rates will lead to a higher exchange rate and depress net exports . Thus , the aggregate demand curve will shift to the left . All other things unchanged , real and the price level will fall . Changes in the Money Supply Now suppose the market for money is in equilibrium and the Fed changes the money supply . All other things unchanged , how will this change in the money supply affect the equilibrium interest rate and aggregate demand , real , and the price level ?

Suppose the Fed conducts operations in which it buys bonds . This is an example of expansionary monetary policy . The impact of Fed bond purchases is illustrated in Panel ( a ) of Figure . In this chapter we are looking only at changes that originate in financial markets to see their impact on aggregate demand and aggregate supply . Changes in the price level and in real also shift the money demand curve , but these changes are the result of changes in aggregate demand or aggregate supply and are considered in more advanced courses in .

Principles of 356 An Increase in the Money Supply . The Fed purchase of bonds shifts the demand curve for bonds to the right , raising bond prices to . As we learned , when the Fed buys bonds , the supply of money increases . Panel ( of Figure An Increase in the Money Supply shows an economy with a money supply of , which is in equilibrium at an interest rate of . Now suppose the bond purchases by the Fed as shown in Panel ( a ) result in an increase in the money supply to that policy change shifts the supply curve for money to the right to . At the original interest rate , people do not wish to hold the newly supplied money they would prefer to hold assets . To reestablish equilibrium in the money market , the interest rate must fall to increase the quantity of money demanded . In the economy shown , the interest rate must fall to to increase the quantity of money demanded to . Figure An Increase in the Money Supply Panel ( a ) Panel ( 13 53 I I ' 35 . I I , a , Quantity of bonds per period Quantity of money per period Real per year The Fed increases the money supply by buying bonds , increasing the demand for bonds in Panel ( a ) from to and the price of bonds to . This corresponds to an increase in the money supply to in Panel ( The interest rate must fall to to achieve equilibrium . The lower interest rate leads to an increase in investment and net exports , which shifts the aggregate demand curve from to in Panel ( Real and the price level rise . The reduction in interest rates required to restore equilibrium to the market for money after an increase in the money supply is achieved in the bond market . The increase in bond prices lowers interest rates , which will increase the quantity of money people demand . Lower interest rates will stimulate investment and net exports , via changes in the foreign exchange market , and cause the aggregate demand curve to shift to the right , as shown in Panel ( from to . Given the aggregate supply curve , the economy moves to a higher real and a higher price level . operations in which the Fed sells is , a monetary have the opposite effect . When the Fed sells bonds , the supply curve of bonds shifts to the right and the price of bonds falls . The bond sales lead to a reduction in the money supply , causing the money supply curve to shift to the left and raising the equilibrium interest rate . Higher interest rates lead to a shift in the aggregate demand curve to the left . As we have seen in looking at both changes in demand for and in supply of money , the process of achieving equilibrium in the money market works in tandem with the achievement of equilibrium in the bond market . The interest rate determined by money market equilibrium is consistent with the interest rate achieved in the bond market .

357 Author removed at request of original publisher Key Ta People hold money in order to buy goods and services ( transactions demand ) to have it available for contingencies ( precautionary demand ) and in order to avoid possible drops in the value of other assets such as bonds ( speculative demand ) The higher the interest rate , the lower the quantities of money demanded for transactions , for precautionary , and for speculative purposes . The lower the interest rate , the higher the quantities of money demanded for these purposes . The demand for money will change as a result of a change in real , the price level , transfer costs , expectations , or preferences . We assume that the supply of money is determined by the Fed . The supply curve for money is thus a vertical line . Money market equilibrium occurs at the interest rate at which the quantity of money demanded equals the quantity of money supplied . All other things unchanged , a shift in money demand or supply will lead to a change in the equilibrium interest rate and therefore to changes in the level of real and the price level . Try It ! In 2005 the Fed was concerned about the possibility that the United States was moving into an gap , and it adopted a monetary policy as a result . Draw a graph showing this policy and its expected results . In Panel ( a ) use the model of aggregate demand and aggregate supply to illustrate an economy with an gap . In Panel ( show how the Fed policy will affect the market for bonds . In Panel ( show how it will affect the demand for and supply of money . In Panel ( show how it will affect the exchange rate . Finally , return to Panel ( a ) and incorporate these developments into your analysis of aggregate demand and aggregate supply , and show how the Fed policy will affect real and the price level in the short run . Case in Point Money in Today World

Principles of 358 , A . Checkbook . The models of the money and bond markets presented in this chapter suggest that the Fed can control the interest rate by deciding on a money supply that would lead to the desired equilibrium interest rate in the money market . Yet , Fed policy announcements typically focus on what it wants the federal funds rate to be with scant attention to the money supply . Whereas throughout the , the Fed would announce a target federal funds rate and also indicate an expected change in the money supply , in 2000 , when legislation requiring it to do so expired , it abandoned the practice of setting money supply targets . Why the shift ?

The factors that have made focusing on the money supply as a policy target difficult for the past 25 years are first banking deregulation in the followed by financial innovations associated with technological particular the maturation of electronic payment and transfer . Before the , was a fairly reliable measure of the money people held , primarily for transactions . To buy things , one used cash , checks written on demand deposits , or traveler checks . The Fed could thus use reliable estimates of the money demand curve to predict what the money supply would need to be in order to bring about a certain interest rate in the money market . Legislation in the early allowed for money market deposit accounts ( which are essentially savings accounts on which checks can be written . are part of . Shortly after , other forms of payments for transactions developed or became more common . For example , credit and debit card use has mushroomed ( from billion in 1990 to 30 billion in 2000 ) and people can pay their credit card bills , electronically or with paper checks , from accounts that are part of either or . Another innovation of the last 20 years is the automatic transfer service ( that allows consumers to move money between checking and savings accounts at an ATM machine , or online , or through prearranged agreements with their financial institutions . While we take these methods of payment for granted today , they did not exist before 1980 because of restrictive banking legislation and the lack of technological . Indeed , before 1980 , being able to pay bills from accounts that earned interest was unheard of . Further blurring the lines between and has been the development and growing popularity of what are called retail sweep programs . Since 1994 , banks have been using software to dynamically

359 Author removed at request of original publisher reclassify balances as either checking account balances ( part of ) or ( part of ) They do this to avoid reserve requirements on checking accounts . The software not only moves the funds but also ensures that the bank does not exceed the legal limit of six in any month . In the last 10 years these retail sweeps rose from zero to nearly the size of itself ! Such changes in the ways people pay for transactions and banks do their business have led economists to think about new definitions of money that would better track what is actually used for the purposes behind the money demand curve . One notion is called , which stands for money zero The idea behind is that people can easily use any deposits that do not have specified maturity terms to pay for transactions , as these accounts are quite liquid , regardless of what classification of money they fall into . Some research shows that using allows for a stable picture of the money market . Until more agreement has been reached , though , we should expect the Fed to continue to downplay the role of the money supply in its policy deliberations and to continue to announce its intentions in terms of the federal funds rate . Source and Zhou , A Stable Money Demand Looking for the Right Monetary Aggregate , Federal Reserve Bank of Chicago Economic Perspectives 29 ( First Quarter , 2005 ) Answer to Try It ! Problem In Panel ( a ) with the aggregate demand curve , aggregate supply curve , and aggregate supply curve , the economy has an inflationary gap of . The monetary policy means that the Fed sells rightward shift of the bond supply curve in Panel ( which decreases the money shown by a leftward shift in the money supply curve in Panel ( In Panel ( we see that the price of bonds falls , and in Panel ( that the interest rate rises . A higher interest rate will reduce the quantity of investment demanded . The higher interest rate also leads to a higher exchange rate , as shown in Panel ( as the demand for dollars increases and the supply decreases . The higher exchange rate will lead to a decrease in net exports . As a result of these changes in financial markets , the aggregate demand curve shifts to the left to in Panel ( a ) If all goes according to plan ( and we will learn in the next chapter that it may not ! the new aggregate demand curve will intersect and at .

Principles of 360 Panel ( a ) Price level Nu Real per year Panel ( Interest rate ( percent ) 02 , Quantity of money per period Price of bonds Exchange rate ( yen per ) Panel ( Quantity of bonds per period Panel ( Quantity of dollars per period Review and Practice Summary We began this chapter by looking at bond and foreign exchange markets and showing how each is related to the level of real and the price level . Bonds represent the obligation of the seller to repay the buyer the face value by the maturity date their interest rate is determined by the demand and supply for bonds . An increase in bond prices means a drop in interest rates . A reduction in bond prices means interest rates have risen . The price of the dollar is determined in foreign exchange markets by the demand and supply for dollars . We then saw how the money market works . The quantity of money demanded varies negatively with the interest rate . Factors that cause the demand curve for money to shift include changes in real , the price level , expectations , the cost of transferring funds between money and accounts , and preferences , especially preferences concerning risk . Equilibrium in the market for money is achieved at the interest rate at which the quantity of money demanded equals the quantity of money supplied . We assumed that the supply of money is by the Fed . An increase in money demand raises the equilibrium interest rate , and a decrease in money demand lowers the equilibrium interest rate . An increase in the money supply lowers the equilibrium interest rate a reduction in the money supply raises the equilibrium interest rate . Concept Problems . What factors might increase the demand for bonds ?

The supply ?

What would happen to the market for bonds if a law were passed that set a minimum price on bonds that was above the equilibrium price ?

When the price of bonds decreases , the interest rate rises . Explain . One journalist writing about the complex interactions between Various markets in the economy stated When the government spends more than it takes in taxes it must sell bonds to finance its excess expenditures . But selling bonds drives interest rates down and thus stimulates the economy by encouraging more investment and decreasing the foreign exchange rate , which helps our export Carefully analyze the statement . Do you agree ?

Why or why not ?

What do you predict will happen to the foreign exchange rate if interest rates in the United States increase dramatically over the next year ?

Explain , using a graph of the foreign exchange market . How would such a change affect real and the price level ?

Suppose the government were to increase its purchases , issuing bonds to finance these purchases . Use your knowledge of the bond and foreign exchange markets to explain how this would affect investment and net exports . How would each of the following affect the demand for money ?

361 Principles of 362 A tax on bonds held by individuals A forecast by the Fed that interest rates will rise sharply in the next quarter A wave of muggings ! An announcement of an agreement between Congress and the president that , beginning in the next fiscal year , government spending will be reduced by an amount sufficient to eliminate all future borrowing . Some countries do not have a bond market . In such countries , what substitutes for money do you think people would hold ?

Explain what is meant by the statement that people are holding more money than they want to hold . 10 . Explain how the Fed sale of government bonds shifts the supply curve for money . 11 . Trace the impact of a sale of government bonds by the Fed on bond prices , interest rates , investment , net exports , aggregate demand , real , and the price level . Numerical Problems . Compute the rate of interest associated with each of these bonds that matures in one year Face Value Selling Price a . 100 80 . 100 90 100 95 200 180 200 190 200 195 Describe the relationship between the selling price of a bond and the interest rate . Suppose that the demand and supply schedules for bonds that have a face value of 100 and a

363 Author removed at request of original publisher maturity date one year hence are as follows Price ( Quantity Demanded Quantity Supplied 100 95 90 85 80 75 70 600 100 500 200 400 300 300 400 200 500 100 600 . Draw the demand and supply curves for these bonds , find the equilibrium price , and determine the interest rate . Now suppose the quantity demanded increases by 200 bonds at each price . Draw the new demand curve and find the new equilibrium price . What has happened to the interest rate ?

Compute the dollar price of a German car that sells for euros at each of the following exchange rates . euro . euro . euro . Consider the of the European Union and Japan . The demand and supply curves for euros are given by the following table ( prices for the euro are given in Japanese yen quantities of euros are in millions ) Price ( in Euros ) Euros Demanded Euros Supplied 75 70 65 60 55 50 45 600 100 500 200 400 300 300 400 200 500 100 600 . Draw the demand and supply curves for euros and state the equilibrium exchange rate ( in yen ) for the euro . How many euros are required to purchase one yen ?

Principles of 364 . Suppose an increase in interest rates in the European Union increases the demand for euros by 100 million at each price . At the same time , it reduces the supply by 100 million at each price . Draw the new demand and supply curves and state the new equilibrium exchange rate for the euro . How many euros are now required to purchase one yen ?

How will the event in ( affect net exports in the European Union ?

How will the event in ( affect aggregate demand in the European Union ?

How will the event in ( affect net exports in Japan ?

57 . How will the event in ( affect aggregate demand in Japan ?

Suppose you earn per month and spend 200 in each of the month 30 days . Compute your average quantity of money demanded if . You deposit your entire earnings in your checking account at the beginning of the month . You deposit into your checking account on the , and days of the month . You deposit into your checking account on the , and days of the month . How would you expect the interest rate to affect your decision to opt for strategy ( a ) Or ( Suppose the quantity demanded of money at an interest rate of is billion per day , at an interest rate of is billion per day , and at an interest rate of is billion per day . Suppose the money supply is billion per day . Draw a graph of the money market and find the equilibrium interest rate . Suppose the quantity of money demanded decreases by billion per day at each interest rate . Graph this situation and find the new equilibrium interest rate . Explain the process of achieving the new equilibrium in the money market . Suppose instead that the money supply decreases by billion per day . Explain the process of achieving the new equilibrium in the money market . We know that the economy faced a recessionary gap in 2008 and that the Fed responded with an expansionary monetary policy . Present the results of the Fed action in a graph . In Panel ( a ) show the initial situation , using the model of aggregate demand and aggregate supply . In Panel ( show how the Fed policy affects the bond market and bond prices . In Panel ( show how the market for dollars and the exchange rate will be affected . In Panel ( incorporate these developments into your analysis of aggregate demand and aggregate supply , and show how the Fed policy will affect real and the price level in the short run .