pump primer : what do you believe is the opportunity cost of holding money? 28

Pump PrimerPump Primer::

• What do you believe is the opportunity cost of holding money?

28

KRUGMAN'SMACROECONOMICS for AP*

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Margaret Ray and David Anderson

ModuleThe MoneyMarket

Biblical IntegrationBiblical Integration

• To be a good steward of God's money takes us back to the parable of the talents (Matt. 25: 14-28) This parable stresses how we as Christians have been given a special gift and what we do with it is more important than any earthly riches.

What you will learnWhat you will learn

in thisin this ModuleModule::

• What the money demand curve is

• Why the liquidity preference model determines the interest rate in the short run

The Demand for MoneyThe Demand for Money

What would cause you to have more money in your pocket today than you had yesterday?

What else can you do with your money. •You can save it!

And what would make you interested in saving it? •A higher interest rate.)

The Opportunity Cost of HoldingThe Opportunity Cost of Holding Money Money

It is convenient to hold money in your pocket because it allows you to conveniently make purchases.

The price of that convenience is that money in your pocket earns no interest.


Suppose you could put $100 in a 12-month CD that would earn 5%. A CD is not very liquid because if you withdraw the money before 12 months, you forfeit up to three months of interest. $100 in your pocket or in your checking account (M1) will come at an opportunity cost of 5% or $5.


Maybe it is easy to pass up $5 to have the convenience of $100 in your pocket. What if the interest rate was 50%? Would you still hold $100 in your pocket when the cost is now $50? If the interest rate was 0.5%, how likely is it that you would put the $100 in a CD? Not very..


Intuitively, this reflects a general result: the higher the short-term interest rate, the higher the opportunity cost of holding money; the lower the short-term interest rate, the lower the opportunity cost of holding money. Why don’t we consider long-term interest rates like 10-year CD’s as the opportunity cost of holding money? Because we hold money to make transactions in the short term. Therefore we must consider the opportunity cost in the short term, not the long term..

The Money Demand CurveThe Money Demand Curve

Since we demand money to make purchases in the short term, the opportunity cost of holding money is the short-term interest rate. We assume that in a short period of time, there will be virtually no inflation, so the nominal interest rate is equal to the real interest rate.


It is this assumption that allows us to put the nominal interest rate on the vertical axis of graph of the money market.

You may lose points on the AP exam if you label this axis as the real interest rate.


As discussed above, when the interest rate rises, the opportunity cost of holding money rises, so the quantity of money demanded will fall.


The money demand curve is downward sloping. An increase in the nominal interest rate will cause a movement upward along the money demand curve.

Shifts of the Money DemandShifts of the Money Demand Curve Curve

Just like there are external factors that shift the demand curve for pomegranates, there are external factors that shift the demand curve for money.if an external change makes holding money in your pocket more desirable at any interest rate, the demand curve for money will shift rightward.)


The most important factors causing the money demand curve to shift are changes in the aggregate price level, changes in real GDP, changes in banking technology, and changes in banking institutions.


1. Changes in the Aggregate Price Level

All else equal, higher prices increase the demand for money (a rightward shift of the MD curve), and lower prices reduce the demand for money (a leftward shift of the MD curve).


We can actually be more specific than this: other things equal, the demand for money is proportional to the price level. That is, if the aggregate price level rises by 20%, the quantity of money demanded at any given interest rate, also rises by 20%. Why? Because if the price of everything rises by 20%, it takes 20% more money to buy the same basket of goods and services.


2. Changes in Real GDP

As the economy gets stronger, real incomes and real GDP rise. The larger the quantity of goods and services we buy, the larger the quantity of money we will want to hold at any given interest rate.


So an increase in real GDP—the total quantity of goods and services produced and sold in the economy—shifts the money demand curve rightward.


3. Changes in Technology

Changes in technology can affect the demand for money. In general, advances in information technology have tended to reduce the demand for money by making it easier for the public to make purchases without holding significant sums of money.

If there was an ATM machine on every corner and in every retail store and restaurant, there would be little need to hold money in your pocket.


4. Changes in Institutions

Regulations that make it more attractive to keep money in banks will reduce the demand for money.

If a nation’s political and banking

systems became dangerously unstable, it might increase the demand for money because people would rather hoard their money than store it in institutions that might be falling apart.

Money and Interest RatesMoney and Interest Rates

The Fed uses the three tools of monetary policy to achieve a target level for the federal funds rate.

Since most interest rates will move closely with the FFR, we can use the money market to show how these policies work.

The Equilibrium Interest RateThe Equilibrium Interest Rate

We assume that the money supply MS is determined by the Fed and is fixed at any given point in time. It is also independent of the interest rate so it is depicted as a vertical line.


Example What would happen to interest rates and the quantity of money demanded if there was some interest rate i1 that was greater than i*? If i1 > i*, the quantity of money supplied exceeds the quantity of money demanded. Why? Because of high interest rates, CDs are very attractive saving options!

Rates fall, the quantity of money demanded gets closer and closer to M*.


In fact, banks find that they can lower the interest rate on CDs and still have plenty of customers ready to buy a CD. As interest rates fall, the quantity of money demanded gets closer and closer to M*.


Example What would happen to interest rates and the quantity of money demanded if there was some interest rate i2 that was less than i*? If i2 < i*, the quantity of money demanded exceeds the quantity of money supplied. Why? Because of low interest rates, CDs are not very attractive saving options!


In fact, banks find that they must raise the interest rate on CDs to get more customers ready to buy a CD. As interest rates rise, the quantity of money demanded gets closer and closer to M*.

Two Models of the Interest RateTwo Models of the Interest Rate

The model of liquidity preference describes equilibrium in the money market.

This model is a good foundation for learning a similar market in loanable funds that is also useful in describing how interest rates are determined and the impact of monetary policy and other more advanced topics

pump primer : what do you believe is the opportunity cost of holding money? 28

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