Financial Markets and the Economy
Site: | Saylor Academy |
Course: | ECON102: Principles of Macroeconomics |
Book: | Financial Markets and the Economy |
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Date: | Sunday, December 3, 2023, 1:49 AM |
Description
Read this chapter to build a foundation for understanding financial markets. The first section discusses the bonds and foreign exchange markets and the way they are connected through the interest rate. The second section builds the model of the money market and connects it to the other financial markets. Pay attention to how the connection is made between the financial markets and the overall economy by showing the effects on the equilibrium real GDP and the price level, using the model of aggregate demand and supply.
Start Up: Clamping Down on Money Growth
For nearly three decades, Americans have come to expect very low inflation, on the order of 2% to 3% 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 three-month Treasury bills soaring past 10%, a desperate President Jimmy Carter took action. He appointed Paul Volcker, the president of the New York Federal Reserve Bank, as chairman of the Fed's Board of Governors. Mr. Volcker made clear that
his objective as chairman was to bring down the inflation rate - no matter what the consequences for the economy. Mr. Carter gave this effort his full support.
Mr. Volcker wasted no time in putting his policies to work. He slowed the rate of
money growth immediately. The economy's response was swift; the United States slipped into a brief recession in 1980, followed by a crushing recession in 1981–1982. In terms of the goal of reducing inflation, Mr. Volcker's monetary policies were a
dazzling success. Inflation plunged below a 4% rate within three years; by 1986 the inflation rate had fallen to 1.1%. The tall, bald, cigar-smoking Mr. Volcker emerged as a folk hero in the fight against inflation. Indeed he has returned 20 years
later as part of President Obama's economic team to perhaps once again rescue the U.S. economy.
The Fed's seven-year fight against inflation from 1979 to 1986 made the job for Alan Greenspan, Mr. Volcker's successor, that much easier. To see
how the decisions of the Federal Reserve affect key macroeconomic variables - real GDP, the price level, and unemployment - in 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
GDP 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 demand
- the quantity of money people and firms want to hold - which, 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 GDP
and the price level. In this chapter, we will learn that changes in the financial markets can affect aggregate demand - and in turn can lead to changes in real GDP 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 macroeconomy works.
This text was adapted by Saylor Academy under
a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensor.
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's interest rate.
- Explain and illustrate the relationship between a change in demand for or supply of bonds and macroeconomic activity.
- Explain and illustrate how the foreign exchange market works and how a
change in demand for a country's currency or a change in its supply
affects macroeconomic 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
The $1,000 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 bond - 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:
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 11.1%. A price of $800 would mean an interest rate of 25%; $750 would mean an interest rate of 33.3%; 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 $1,000 and $100,000) 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 10.1 "The Bond Market" illustrates the market for bonds. Their price is determined by demand and supply. Buyers of newly issued bonds are, in effect, lenders. Sellers of newly issued bonds are borrowers - recall 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.
Figure 10.1 The Bond Market

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 downward-sloping demand curves and upward-sloping 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 borrowers - suppliers of bonds - and 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 10.1 "The Bond Market". We will assume that all bonds have equal risk and a face value of $1,000 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 S1 to S2. That, in turn, lowers the equilibrium price of bonds - to $900 in Figure 10.1 "The Bond Market". The lower price for bonds means a higher interest rate.
The Bond Market and Macroeconomic Performance
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 10.2 "Bond Prices and Macroeconomic Activity" shows how an event in the bond market can stimulate changes in the economy's 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 AD1 to AD2 in Panel (b). Real GDP rises from Y1 to Y2; the price level rises from P1 to P2. In Panel (c), 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 AD1 to AD2 in Panel (d). Output and the price level fall from Y1 to Y2 and from P1 to P2, respectively. Assuming other determinants of aggregate demand remain unchanged, higher interest rates will tend to reduce aggregate demand and lower interest rates will tend to increase aggregate demand.

An increase in the supply of bonds to S2 lowers bond prices to Pb2 in Panel (c) and raises interest rates. The higher interest rate, taken by itself, is likely to cause a reduction in investment and aggregate demand. AD1 falls to AD2, real GDP falls to Y2, and the price level falls to P2 in Panel (d).
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
macroeconomic variables is the foreign exchange market, a market in
which currencies of different countries are traded for one another.
Since changes in exports and imports affect aggregate demand and thus
real GDP 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 U.S. 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 U.S. 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's 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 91.13 Japanese
yen, 0.75 euros, 10.11 South African rands, and 13.51 Mexican pesos.
There are as many exchange rates for the dollar as there are countries
whose currencies exchange for the dollar - roughly 200 of them.
Economists
summarize the movement of exchange rates with a trade-weighted exchange
rate, which is an index of exchange rates. To calculate a
trade-weighted exchange rate index for the U.S. dollar, we select a
group of countries, weight the price of the dollar in each country's
currency by the amount of trade between that country and the United
States, and then report the price of the dollar based on that
trade-weighted average. Because trade-weighted 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
U.S. 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 dollar - the exchange rate - rises. Consequently, the
demand curve for dollars is downward sloping, as in Figure 10.3
"Determining an Exchange Rate".
Figure 10.3 Determining an Exchange Rate

The
equilibrium exchange rate is the rate at which the quantity of dollars
demanded equals the quantity supplied. Here, equilibrium occurs at
exchange rate E, at which Q 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 U.S. buyers, so U.S. 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 10.3 "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 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 Macroeconomic Performance
People
purchase a country's currency for two quite different reasons: to
purchase goods or services in that country, or to purchase the assets of
that country - its 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 10.4 "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 U.S. bond market increases from S1 to S2 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 U.S. bonds. Panel (b) shows
that the demand curve for dollars shifts from D1 to D2. Simultaneously,
U.S. 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 U.S.
bonds shifts the supply curve for dollars on the foreign exchange market
from S1 to S2, and the exchange rate rises from E1 to E2.
Figure 10.4 Shifts in Demand and Supply for Dollars on the Foreign Exchange Market

In
Panel (a), an increase in the supply of bonds lowers bond prices to Pb2
(and thus raises interest rates). Higher interest rates boost the
demand and reduce the supply for dollars, increasing the exchange rate
in Panel (b) to E2. These developments in the bond and foreign exchange
markets are likely to lead to a reduction in net exports and in
investment, reducing aggregate demand from AD1 to AD2 in Panel (c). The
price level in the economy falls to P2, and real GDP falls from Y1 to
Y2.
The higher exchange rate makes U.S. goods and services more
expensive to foreigners, so it reduces exports. It makes foreign goods
cheaper for U.S. buyers, so it increases imports. Net exports thus fall,
reducing aggregate demand. Panel (c) shows that output falls from Y1 to
Y2; the price level falls from P1 to P2. This development in the
foreign exchange market reinforces the impact of higher interest rates
we observed in Figure 10.2 "Bond Prices and Macroeconomic Activity",
Panels (c) and (d). They not only reduce investment - they reduce net
exports as well.
Key Takeaways
- A bond represents a borrower's 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 U.S. goods, services, and assets. The supply of dollars on foreign exchange markets represents U.S. demand for foreign goods, services, and assets. The demand for and the supply of dollars determine the exchange rate.
- A rise in U.S. 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 U.S. interest
rates will have the opposite effect.
Case in Point: Bill Gross's Mea Culpa

In October 2011, bond fund
manager Bill Gross sent out an extraordinary open letter titled "Mea
Culpa". He was taking the blame for the poor performance of Pimco Total
Return Bond Fund, the huge fund he manages. After years of stellar
performance, what had gone wrong?
Earlier in 2011, Mr. Gross
announced that he would avoid U.S. Treasury bonds. He assumed that as
the U.S. and other countries' economies recovered, interest rates would
begin to rise and, hence, U.S. bond prices would fall. When Mr. Gross
pulled out of U.S. 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 countries - starting with Greece and then
spilling over to Portugal, Spain, Italy, and others - investors around
the world flocked toward Treasuries, pushing Treasury bond prices up. It
was a rally that Mr. Gross's 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 Pimco fund portfolio. As a result, the prices of bonds in the
Pimco fund fell.
In the letter, Mr. Gross wrote, "The simple fact
is that the portfolio at midyear was positioned for what we call a 'New
Normal' developed world economy - 2% real growth and 2% inflation. When
growth estimates quickly changed it was obvious that I had misjudged
the fly ball: E-CF or for nonbaseball aficionados - error centerfield".
In the fall of 2011, he shifted gears and began buying U.S. 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
five-star rating by Morningstar in 2012. We must wait to see whether Mr.
Gross will get his groove back. In the letter, he concluded, "There is
no 'quit' in me or anyone else on the Pimco 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. I/we respect our competition but we want to squash them
each and every day…"
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 GDP 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 determinants 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 macroeconomy.
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 long-term 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.
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 health-care 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'll 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. Bondholders 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
bondholders 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 cannot sort through
someone's 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's motives for holding money.
The
quantity of money households want to hold varies according to their
income and the interest rate; different average quantities of money held
can satisfy their transactions and precautionary demands for money. To
see why, suppose a household earns and spends $3,000 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 $3,000 in the checking
account when the month begins, $2,900 at the end of the first day,
$1,500 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 $1,500. 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
$1,000 in its checking account and the other $2,000 in a bond fund.
Assume the bond fund pays 1% interest per month, or an annual interest
rate of 12.7%. After 10 days, the money in the checking account is
exhausted, and the household withdraws another $1,000 from the bond fund
for the next 10 days. On the 20th day, the final $1,000 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
approach".
Remember that both approaches allow the household to
spend $3,000 per month, $100 per day. The cash approach requires a
quantity of money demanded of $1,500, while the bond fund approach
lowers this quantity to $500.
The bond fund approach generates
some interest income. The household has $1,000 in the fund for 10 days
(1/3 of a month) and $1,000 for 20 days (2/3 of a month). With an
interest rate of 1% per month, the household earns $10 in interest each
month ([$1,000 × 0.01 × 1/3] + [$1,000 × 0.01 × 2/3]). The disadvantage
of the bond fund, of course, is that it requires more attention - $1,000
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 $1,500 in the checking account and $1,500 in the
bond fund, transferring $1,500 to the checking account midway through
the month. This strategy requires one less transfer, but it also
generates less interest - $7.50 (= $1,500 × 0.01 × 1/2). 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 interest-earning asset as a bond fund
strategy.
Which approach should the household use? That is a
choice each household must make - it 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 clear-cut 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.
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 1970s and 1980s, that allowed easy transfer of funds between
interest-earning 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 $3,000 per month, even a relatively small firm
may be concerned about $3,000,000 per month. Rather than facing the
difference of $10 versus $7.50 in interest earnings used in our
household example, this small firm would face a difference of $2,500 per
month ($10,000 versus $7,500). For very large firms such as Toyota or
AT&T, 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
prices - low interest rates - would 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 10.5 "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.
Figure 10.5 The Demand Curve for Money

The
demand curve for money shows the quantity of money demanded at each
interest rate. Its downward slope expresses the negative relationship
between the quantity of money demanded and the interest rate.
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 rate - or the
differential between the interest rate in the bond market and the
interest paid on money deposits - represents the price of holding money.
As is the case with all goods and services, an increase in price
reduces the quantity demanded.
Other Determinants 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 determinants of money demand
unchanged. A change in those "other determinants" 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 GDP, the price level,
expectations, transfer costs, and preferences.
Real GDP
A
household with an income of $10,000 per month is likely to demand a
larger quantity of money than a household with an income of $1,000 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 GDP increases
incomes throughout the economy. The demand for money in the economy is
therefore likely to be greater when real GDP 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
self-fulfilling 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 1920s, prices were doubling as often as
three times a day. Under those circumstances, people tried not to hold
money even for a few minutes - within the space of eight hours money
would lose half its value!
Transfer Costs
For a given level of
expenditures, reducing the quantity of money demanded requires more
frequent transfers between nonmoney 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 nonmoney 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 bondholders; indeed, bond issuers
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's
attitudes about the trade-off 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 10.6 "An Increase in Money Demand" shows an
increase in the demand for money. Such an increase could result from a
higher real GDP, a higher price level, a change in expectations, an
increase in transfer costs, or a change in preferences.
Figure 10.6 An Increase in Money Demand

An
increase in real GDP, the price level, or transfer costs, for example,
will increase the quantity of money demanded at any interest rate r,
increasing the demand for money from D1 to D2. The quantity of money
demanded at interest rate r rises from M to M′. 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 determinants of supply unchanged. We have
learned that the Fed, through its open-market 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 10.7 "The Supply
Curve of Money" as a vertical line, determined by the Fed's 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.
Figure 10.7 The Supply Curve of Money

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 10.8
"Money Market Equilibrium" combines demand and supply curves for money
to illustrate equilibrium in the market for money. With a stock of money
(M), the equilibrium interest rate is r.
Figure 10.8 Money Market Equilibrium

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 r.
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's look at the effects of such changes on the economy.
Changes in Money Demand
Suppose
that the money market is initially in equilibrium at r1 with supply
curve S and a demand curve D1 as shown in Panel (a) of Figure 10.9 "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 nonmoney deposits, from a change in expectations, or from a change
in preferences.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 GDP 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 macroeconomics. Panel (a) shows that the money
demand curve shifts to the left to D2. We can see that the interest rate
will fall to r2. 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 (b) 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 10.9 A Decrease in the Demand for Money

A
decrease in the demand for money due to a change in transactions costs,
preferences, or expectations, as shown in Panel (a), will be
accompanied by an increase in the demand for bonds as shown in Panel
(b), and a fall in the interest rate. The fall in the interest rate will
cause a rightward shift in the aggregate demand curve from AD1 to AD2,
as shown in Panel (c). As a result, real GDP and the price level rise.
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
(c) from AD1 to AD2. Given the short-run aggregate supply curve SRAS,
the economy moves to a higher real GDP 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 GDP 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 GDP, and
the price level?
Suppose the Fed conducts open-market 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 10.10 "An Increase in the Money Supply". The Fed's purchase of
bonds shifts the demand curve for bonds to the right, raising bond
prices to Pb2. As we learned, when the Fed buys bonds, the supply of
money increases. Panel (b) of Figure 10.10 "An Increase in the Money
Supply" shows an economy with a money supply of M, which is in
equilibrium at an interest rate of r1. Now suppose the bond purchases by
the Fed as shown in Panel (a) result in an increase in the money supply
to M′; that policy change shifts the supply curve for money to the
right to S2. At the original interest rate r1, people do not wish to
hold the newly supplied money; they would prefer to hold nonmoney
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 r2 to increase the
quantity of money demanded to M′.
Figure 10.10 An Increase in the Money Supply

The
Fed increases the money supply by buying bonds, increasing the demand
for bonds in Panel (a) from D1 to D2 and the price of bonds to Pb2. This
corresponds to an increase in the money supply to M′ in Panel (b). The
interest rate must fall to r2 to achieve equilibrium. The lower interest
rate leads to an increase in investment and net exports, which shifts
the aggregate demand curve from AD1 to AD2 in Panel (c). Real GDP 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 (c), from AD1 to
AD2. Given the short-run aggregate supply curve SRAS, the economy moves
to a higher real GDP and a higher price level.
Open-market
operations in which the Fed sells bonds - that is, a contractionary
monetary policy - will 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.
Key Takeaways
- 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 GDP, 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 GDP and the price level.
Case in Point: Money in Today's World
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
1990s, 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 1980s followed
by financial innovations associated with technological changes - in
particular the maturation of electronic payment and transfer mechanisms -
thereafter.
Before the 1980s, M1 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's 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 1980s allowed for money market deposit accounts (MMDAs), which are
essentially interest-bearing savings accounts on which checks can be
written. MMDAs are part of M2. Shortly after, other forms of payments
for transactions developed or became more common. For example, credit
and debit card use has mushroomed (from $10.8 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 M1 or M2. Another innovation of the last 20 years is the
automatic transfer service (ATS) 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 know-how. Indeed, before 1980, being able to pay bills
from accounts that earned interest was unheard of.
Further
blurring the lines between M1 and M2 has been the development and
growing popularity of what are called retail sweep programs. Since 1994,
banks have been using retail-sweeping software to dynamically
reclassify balances as either checking account balances (part of M1) or
MMDAs (part of M2). 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
reclassifications in any month. In the last 10 years these retail sweeps
rose from zero to nearly the size of M1 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 MZM, which stands for "money zero maturity".
The idea behind MZM 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 MZM 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.
Summary
We
began this chapter by looking at bond and foreign exchange markets and
showing how each is related to the level of real GDP 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 GDP, the price level, expectations, the
cost of transferring funds between money and nonmoney 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 determined 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.