Financial Markets and the Economy
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.
Demand, Supply, and Equilibrium in the Money Market
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
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.