Money supply and demand impacting interest rates (video) | Khan Academy
Sep 10, OMOs are tools in monetary policy that allow a central bank to control the money supply in an economy. Under a contractionary policy, a central. Feb 12, Read about the link between the supply of money and market interest rates, and find out why money supply alone can't explain interest rates. Nov 1, Learn through graphs and explanations how money supply and money How Money Supply and Demand Determine Nominal Interest Rates is graphed as the relationship between the interest rate and quantity of money.
Let's say this is the Fed prints and lends money. Their lending the money by buying government bonds. When you buy a government bond, your essentially lending that money to the Federal Government. I've done other videos on that where we go into a little bit more detail on that. Let's think of another situation. Let's think about consumer savings go down. One interesting thing about savings, savings and investment are two opposite sides of the same coin. When you save money You have the whole financial system right over here.
This is the finincial system. That money goes out and is lent to other people. For the most part, hopefully, that money when it's lent is used to invest in someway. If consumer savings goes down that means the supply of money will be shifted to the left. At any given price and any given interest rate their be less money available. In this situation our supply curve is shifting to the left.
That would increase interest rates. Then you could even make an argument that if consumers savings is going down consumers are going to borrow less as well. You could argue that maybe demand would go up as well. Your demand could go up and that would make the equilibrium interest rate even even higher. Let's do another scenario. Let's say that the Federal Government in an effort to The government decides to borrow a lot more money.
The government is essentially going expand it's deficit. The government is going to borrow money. Here our supply isn't changing. I'm assuming the Central Bank isn't changing it's policies, how much it's printing. Savings rates aren't changing.
The demand is going to go up. Government is borrowing money. The government is going to borrow more money than it was already doing. At any given price the demand for money is going to increase. We're going to shift to the right, and our new equilibrium interest rate, remember the rental price of money, is going to go up. The whole point of this is just to show you that you really can't think about money like any other good or service.
If the supply of money goes up then the price of money, which is interest rates, will go down. Let me write this down. If the supply goes up then the price, which is just the interest rates goes down. If the demand goes up, then the price of money will go up. Interest rates will go up. Then we think about all the other combinations where demand goes down, then interest would go down.
Which is essentially just price. If supply went down, interest rates would go up. If something becomes more scarce the price of it goes up.
The whole point of this is just to show that it's not that complicated. You'll see people say, oh, government borrowing, it's crowding out other savings, interest rates go up, and it sounds like something deep is happening.
They are just talking about the supply and demand for money. You just have to remember that interest rates really are nothing more than the rental price for money. 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 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: 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 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 The money people hold for contingencies. Money held for precautionary purposes may include checking account balances kept for possible home repairs or health-care needs. 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 The money held in response to concern that bond prices and the prices of other financial assets might change. Of course, money is money. 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: 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 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.
It spends an equal amount of money each 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.
Consider an alternative money management approach that permits the same pattern of spending. The bond fund approach generates some interest income.
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 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 s and s, 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. 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.
Demand, Supply, and Equilibrium in the Money Market
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 Curve that shows the quantity of money demanded at each interest rate, all other things unchanged.
Such a curve is shown in Figure An increase in the interest rate reduces the quantity of money demanded. A reduction in the interest rate increases the quantity of money demanded. 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.
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. That relationship suggests that money is a normal good: 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.
Money supply and demand impacting interest rates
Toward the end of the great German hyperinflation of the early s, 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.