There are different definitions of money. For our purposes here, we define it as currency in circulation, checking account deposits, and traveler's checks—balances held in the form of ready cash.
When households and firms earn income, thev convert some of it into goods for consumption or production, and set aside the rest. Thev can either hold this remaining amount as cash balances or use it to earn inreresr income bv depositing it in a bank savings account or buying interest bearing securities.
How much households and firms choose to hold in cash balances, or their demand for money, is largely determined bv interest rates. Think of the interest that could be earned on money deposited in a savings account or monev market fund as the opportunity cost of holding monev (cash balances).
The relation between short-term interest rates and the quantity of monev that firms and households demand to hold is illustrated in Figure 1, where the downward slope indicates that at lower interest rates, firms and households choose to hold more money. At higher interest rates, the opportunity cost of holding money increases, and firms and households will desire to hold less money and more interest bearing financial assets.
The supply of money is determined by the central bank (the Fed in the U.S.) and is independent of the interest rate. This accounts for the vertical (perfectly inelastic) supply curve in Figure 1.
Figure I: The Supply and Demand for Money
Now if we measure the money supply in nominal currency units, it will be sensitive to the price level. As inflation increases, households and businesses need more money to buy costlier goods and services. If prices doubled, firms and households would need approximately twice the amount of money to fund their purchases and to meet their needs for money in reserve. If we divide the nominal supply of money by the price level (a price index), we have the money supply in real terms. We can think of the real monev supply as the money supply in terms of constant purchasing power. The equilibrium interest rate in Figure 1, i*, is the interest rate for which the demand to hold real money balances is just equal to the real money supply.
If real gross domestic product (GDP) rises, more goods and services are bought and sold, and more money is needed to conduct these transactions. Increases in real GDP shift the money demand curve up. Decreases in real GDP shift it down so that less money is demanded at each level of interest rates.
The increased use of credit cards and debit cards, the availability of interest bearing checking accounts, easier transfer of funds from savings to checking, the proliferation of ATMs, and internet banking and bill paving are all financial innovations thai have affected the demand for monev curve. Overall, financial innovation has reduced the demand for monev below what it would have been if onlv the increase in real GDP was at work. The increased use of credit cards and the proliferation of ATMs have likelv been the most important innovations with respect to the demand for money.
LOS 24.h: Explain interest rate determination, and the short-run and long-run effects of money on re? I GDP.
Interest rates are determined by the equilibrium between money supply and monev demand. As illustrated in Figure 2, if the interest rate is above the equilibrium rate
there is excess supply of real money. Firms and households are holding more real money balances than thev desire to, given the opportunity cost of holding money balances. They will purchase securities to reduce their money balances, which will decrease the interest rate as securities prices are bid up. If interest rates are below equilibrium (i| ), there is excess demand for real money balances, as illustrated in Figure 2. Firms and households will sell securities to increase their money holdings to the desired level, decreasing securities prices and increasing the interest rate.
Figure 2: Disequilibrium in the Money Market
Rare Money Supply
At ihi h, there is excess supply of money leading to purchases o!
At i , there is excess demand for money leading to sales of securities
Let's look at how the central bank can affect interest rates by examining the effects of open market operations on the equilibrium interest rate when the money supply is changed. Consider a situation where the central bank wants to decrease short-term interest rates and will do so by buying securities in the open market. The cash paid for the securities increases the real money supply and bank reserves, which leads to a further increase in the real money supply as banks make loans based on the increase in excess reserves. This shifts the real money supply curve to the right as illustrated in Figure 3. At the previous equilibrium interest rate of 5%, there is now excess supply of money balances. To reduce their money holdings, firms and households buy securities, increasing securities prices and decreasing interest rates until the new equilibrium interest rate in Figure 3 (4%) is achieved. Of course, if the central bank sold securities to decrease the money supply, excess demand for real money balances would result in sales of securities and an increase in the interest rate.
Figure 3: An Increase in the Money Supply Decreases the Interest Rate
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