MONEY AND INTEREST RATE
x A brief review—why we want to hold money?
x The cost of holding money and the demand for money.
x The relationship between bond prices and interest rates.
x The inverse relationship between interest rate and investment—a revisit.
x The relationship between money supply, interest rate, and investment.
x How does the central bank affect the money supply?
A Brief Review—Why We Want to Hold Money?
What “Money” Means in Economics
x Money is the most liquid asset in our economy, an asset is said to be very liquid if it can easily be converted into goods and services
(i.e., easy to buy stuffs).
x Obviously, there are other ways to store value (i.e., hold our wealth in other forms of assets) that are not so liquid.
o Examples of illiquid assets include real estate, cars and etc.
x To some extent, the choice to hold money is a choice among different assets (called “portfolio choices”).
o We ask the question: What is the portion of our wealth that we want to hold in form of liquid asset (money)?
o In economics, the phrase “we have a lot of money” means we have chosen to hold a larger portion of our wealth in the form
of liquid asset.
o For everyone else, the phrase “we have a lot of money” means we are wealthy.
The Cost of Holding Money and the Demand for Money
The Cost of Holding Money
x Question: What is the opportunity cost of holding money?
x Answer: The opportunity cost of holding money is the interest rate. Why?
o Recall, to some extent, the choice to hold money is a choice among different assets.
o When we decide to hold our wealth in form of money, we give up the opportunity to hold our wealth in other form of assets.
o The value of money DOES NOT “grow” and give us any interest. (Think about what happens if you put a $100 bill under
your pillow tonight and then take it out a year later; it is the same $100.)
o However, other assets such as bonds give us a return such as interest.
o Therefore, the opportunity cost of holding money is the interest rate (the rate of return we could have earned if we hold our
wealth in the form of bonds and etc.).
x Question: What happens to the cost of holding money when interest rate rises?
x Answer: When interest rate increases, cost of holding money increases.
o We hold less money and more other interest-bearing assets.
o Demand for money decreases
The Demand for Money
x The demand for money (MD) depends on:
1) Income, Y
o We hold money as a means to facilitate our daily purchases.
o Holding all else constant, when Y increases, our purchases of goods and services increases Æ demand for money increases.
o There is a positive relationship Y and MD.
2) Interest rate, r
o Holding all else constant, when r increases, cost of holding money increases Æ demand for money decreases.
o There is a negative relationship between r and MD.
x In notation form:
MD = demand for liquidity = L (r, Y)
L is the liquidity function
It represents all liquidity for money
x In economics, we also call the demand for money as a demand for liquidity because money is the most liquid asset in the economy.
If we want to hold more money, this means we want to hold more liquid assets.
x In real life the decision of holding money is more complicated. Why?
o Money also serves as a store of value.
o However, if the assets become less liquid (i.e., it takes a longer time to be converted into goods and services), the rates of
return of these assets tend to rise because investors need higher returns to compensate for the fact that the assets cannot be
used to buy stuffs easily.
The Relationship between Bond Prices and Interest Rates
1) There are only two assets in the economy: cash and bonds.
2) Money (cash) does not give any returns to its holders.
3) Bonds give a return to its holders but it is not liquid as cash.
x Based on these assumptions, we know that the choice of holding money is the choice between holding cash and holding bonds.