Economics
The Money Market and The Interest RateDo people always want as much money as possible? YES. However, when we talk about demand we know that there are sacrifices that have to be given up, specifically every individual faces a constraint. So the demand for money is how much money people would like to hold, given the constraints that they face. Money is one of the forms in which people hold their wealth. At a given time, the total amount of wealth is given. If we want to hold more wealth in the form of money, we must hold less wealth in other forms - savings account, money market funds, time deposits, stocks, etc. An individual's quantity of money demanded is the amount of wealth that the individual chooses to hold as money, rather than as other assets. Why do people want to hold more money? The most important reason is that money is a means of payment. Other forms of wealth are not used for purchases. The other forms of wealth provide a financial return to their owners. Money, pays either zero (cash or non-interest bearing checking accounts) or very little (some types of checking accounts) interest. When you hold money, you bear an opportunity cost - the interest you could have ea
To lower the interest rate, the Fed increases the money supply through open market purchases of bonds, so the money supply curve shifts rightward. When the interest rate is lower families find it more affordable to buy homes. Assumption - individuals choose how to divide wealth between two assets: (1) money, which can be used as a means of payment but earns no interest; and (2) bonds, which earn interest, but cannot be used as a means of payment. The greater the interest rate, the greater the opportunity cost of holding money. Equilibrium in the Money MarketLet's combine what we have to determine the equilibrium interest rate in the economy. Let's say that instead you bought the bond for a price of 900 then the gov't is paying you 900/1000=11% interest. The Economy Wide Demand for MoneyThe (economy wide) quantity of money demanded is the amount of total wealth in the economy that all households and businesses, together, choose to hold as money rather than bonds. So when money supply and money demand are equal, all of the money in the economy is being willingly held. As we move along the money demand curve, the interest rate changes, but other determinants of money demand are assumed to remain unchanged. The Fed can not just declare that the interest rate is lower, it has to change the equilibrium interest rate in the money market and it does this by changing the money supply. However, remember that the classical model only holds in the long-run. The Money Demand CurveInterest Rate 6% E 3% F 500 800 Money ($billions) Money demand curve - a curve indicating how much money will be willingly held at each interest rate. People are satisfied holding the money that they are actually holding. These are called durable goods because they last several year and people often borrow to buy consumer durables.
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