Explain the effect of the following events on the interest...

Name: Problem 27, Chapter 13: Macroeconomics
Uploaded: 2019-06-12T22:13:06-08:00
Duration: 5 min 14 s
Channel: Alex Loukas
Description: Explain the effect of the following events on the interest rate in the money market. Demonstrate your answer graphically. a. The supply of money increases. b. A significant number of people begin to use credit cards for daily transactions, reducing the amount of money they hold. c. Bond traders expect bond prices to rise, and therefore reduce their cash holdings. LO8

Explain the effect of the following events on the interest rate in the money market. Demonstrate your answer graphically. a. The supply of money increases. b. A significant number of people begin to use credit cards for daily transactions, reducing the amount of money they hold. c. Bond traders expect bond prices to rise, and therefore reduce their cash holdings. LO8

Explain the effect of the following events on the interest rate in the money market. Demonstrate your answer graphically.
a. The supply of money increases.
b. A significant number of people begin to use credit cards for daily transactions, reducing the amount of money they hold.
c. Bond traders expect bond prices to rise, and therefore reduce their cash holdings. LO8

Key Concepts

Expectations and Asset Choices

Market participants’ expectations about future asset prices (such as bonds) can influence their liquidity choices. For example, if traders expect bond prices to rise, they may hold less cash in favor of bonds, effectively reducing the money demand. This shift can lead to adjustments in the equilibrium interest rate in the money market.

Credit Substitution Effect

This concept highlights the idea that when alternative payment methods (such as credit cards) are adopted, individuals require less cash for daily transactions. This reduction in demand for physical money shifts the money demand curve, potentially leading to lower interest rates as less cash is needed to maintain liquidity.

Money Market Equilibrium

This concept refers to the point at which the quantity of money demanded equals the quantity of money supplied, determining the prevailing interest rate. In a graphical analysis, the intersection of the money supply curve (vertical in the short run because it is policy-determined) and the money demand curve (downward sloping) establishes this equilibrium.

Supply and Demand Analysis

This framework is used to analyze how shifts in either the supply or the demand for money affect the equilibrium interest rate. An increase in the money supply shifts the supply curve to the right, leading to a lower equilibrium interest rate, while changes in money demand due to alterations in payment methods or asset preferences shift the demand curve, influencing the interest rate accordingly.

Liquidity Preference

Liquidity preference theory explains that individuals hold assets as cash (or liquid assets) for transactions and precautionary purposes. Changes in preferences or technological innovations (e.g., use of credit cards) affect how much cash people want to hold, thereby impacting the money demand and influencing the equilibrium interest rate.

Transcript

0:00 Hi everyone.

00:02 Today we're starting chapter 34 with question one, where we're being asked to explain how each of the following developments would affect the supply of money, the demand for money, and the interest rate.

00:13 And we should illustrate our answers with diagrams.

00:17 All right.

00:17 So first of all, we need to determine what is the right kind of diagram we're going to be using.

00:22 Since all our questions deal with the money market, it makes sense to use a simple supply and demand graph for the money market.

00:31 Namely, on the x -axis we have the quantity of money, m.

00:35 On the y -axis we have the interest rate r.

00:39 The money supply curve will always be vertical because it's fixed by the central bank exogenously, and the money -demand curve will be downward sloping.

00:49 Now, just a quick reminder, why is the money -demand curve downward sloping? according to the theory of liquidity preference that we learned in chapter 34, the interest rate is the opportunity cost of holding money.

01:03 That is when you hold wealth as cash in your wallet instead of as an interest bearing bond, you'd lose the interest you could have earned.

01:13 As a result, an increase in the interest rate raises the cost of holding money and consequently reduces the quantity of money demanded, and vice versa.

01:23 So we see there is a negative relation between the interest rate and money holdings and hence the curve will be downward sloping.

01:31 All right, so part one asks, what happens when the feds, bond traders, buy bonds in open market operations? well, this is not a very difficult question because we know that when the feds, bond traders buy bonds, they increase the supply of money in the economy.

01:51 So the money supply curve will move from ms1, ms2.

01:55 There's a shift to the right.

01:57 And since this dissects the downward sloping on a demand curve at a lower point, our equilibrium interest rate will be lower.

02:05 We move from r1, r2.

02:08 And of course, this makes sense.

02:10 Since the buying of bonds in open market operations injects money to the economy, money becomes more abundant, and hence the interest they're going to be bearing.

02:20 It must be lower...

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