The Relationship Between Bonds and Interest Rates- Wells Fargo Funds
definition of money, but the large interest-bearing bank deposits Expected returns/interest rate on money relative to the The condition for equilibrium in the money market is: Ms = Md . In the long run, there is a direct relationship between. A. The money market determines the interest rate. will focus on since they give us the links between the money market and the goods market). and attach an expected rate of return to it with confidence, then at an interest rate of ten percent . rate on loans to enterprises up to one year minus six-month money market rate. Chart A1: Spread between comparable market interest rate and bank deposit rate bond yield minus rate on deposits with an agreed maturity of over two years.
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. 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.
The Relationship Between Bonds and Interest Rates
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.
There is also a chance that the issuer of a bond will default, that is, will not pay the amount specified on the bond to bondholders; indeed, bond issuers may end up paying nothing at all.
A money deposit, such as a savings deposit, might earn a lower yield, but it is a safe yield. Heightened concerns about risk in the last half of led many households to increase their demand for money. Such an increase could result from a higher real GDP, a higher price level, a change in expectations, an increase in transfer costs, or a change in preferences. The reverse of any such events would reduce the quantity of money demanded at every interest rate, shifting the demand curve to the left.
The Supply of Money The supply curve of money Curve that shows the relationship between the quantity of money supplied and the market interest rate, all other determinants of supply unchanged. We have learned that the Fed, through its open-market operations, determines the total quantity of reserves in the banking system. We shall assume that banks increase the money supply in fixed proportion to their reserves. Because the quantity of reserves is determined by Federal Reserve policy, we draw the supply curve of money in Figure In drawing the supply curve of money as a vertical line, we are assuming the money supply does not depend on the interest rate.
Changing the quantity of reserves and hence the money supply is an example of monetary policy. The supply curve of money is a vertical line at that quantity.
Equilibrium in the Market for Money The money market The interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money. Money market equilibrium The interest rate at which the quantity of money demanded is equal to the quantity of money supplied. With a stock of money Mthe equilibrium interest rate is r. Here, equilibrium occurs at interest rate r. Effects of Changes in the Money Market A shift in money demand or supply will lead to a change in the equilibrium interest rate.
Changes in Money Demand Suppose that the money market is initially in equilibrium at r1 with supply curve S and a demand curve D1 as shown in Panel a of Figure Now suppose that there is a decrease in money demand, all other things unchanged.
A decrease in money demand could result from a decrease in the cost of transferring between money and nonmoney deposits, from a change in expectations, or from a change in preferences. In this chapter we are looking only at changes that originate in financial markets to see their impact on aggregate demand and aggregate supply. Changes in the price level and in real GDP also shift the money demand curve, but these changes are the result of changes in aggregate demand or aggregate supply and are considered in more advanced courses in macroeconomics.
Panel a shows that the money demand curve shifts to the left to D2. We can see that the interest rate will fall to r2. To see why the interest rate falls, we recall that if people want to hold less money, then they will want to hold more bonds.
Thus, Panel b shows that the demand for bonds increases. The higher price of bonds means lower interest rates; lower interest rates restore equilibrium in the money market. The fall in the interest rate will cause a rightward shift in the aggregate demand curve from AD1 to AD2, as shown in Panel c.
As a result, real GDP and the price level rise. Lower interest rates in turn increase the quantity of investment. They also stimulate net exports, as lower interest rates lead to a lower exchange rate. An increase in money demand due to a change in expectations, preferences, or transactions costs that make people want to hold more money at each interest rate will have the opposite effect. The money demand curve will shift to the right and the demand for bonds will shift to the left.
The resulting higher interest rate will lead to a lower quantity of investment. Also, higher interest rates will lead to a higher exchange rate and depress net exports. Thus, the aggregate demand curve will shift to the left. All other things unchanged, real GDP and the price level will fall. Changes in the Money Supply Now suppose the market for money is in equilibrium and the Fed changes the money supply.
All other things unchanged, how will this change in the money supply affect the equilibrium interest rate and aggregate demand, real GDP, and the price level?
Suppose the Fed conducts open-market operations in which it buys bonds. This is an example of expansionary monetary policy. The impact of Fed bond purchases is illustrated in Panel a of Figure As we learned, when the Fed buys bonds, the supply of money increases.
Panel b of Figure At the original interest rate r1, people do not wish to hold the newly supplied money; they would prefer to hold nonmoney assets. To reestablish equilibrium in the money market, the interest rate must fall to increase the quantity of money demanded. The interest rate must fall to r2 to achieve equilibrium.
The lower interest rate leads to an increase in investment and net exports, which shifts the aggregate demand curve from AD1 to AD2 in Panel c.
Real GDP and the price level rise. The reduction in interest rates required to restore equilibrium to the market for money after an increase in the money supply is achieved in the bond market.
The increase in bond prices lowers interest rates, which will increase the quantity of money people demand. Lower interest rates will stimulate investment and net exports, via changes in the foreign exchange market, and cause the aggregate demand curve to shift to the right, as shown in Panel cfrom AD1 to AD2. Open-market operations in which the Fed sells bonds—that is, a contractionary monetary policy—will have the opposite effect.
When the Fed sells bonds, the supply curve of bonds shifts to the right and the price of bonds falls. The bond sales lead to a reduction in the money supply, causing the money supply curve to shift to the left and raising the equilibrium interest rate. Higher interest rates lead to a shift in the aggregate demand curve to the left.
As we have seen in looking at both changes in demand for and in supply of money, the process of achieving equilibrium in the money market works in tandem with the achievement of equilibrium in the bond market. The interest rate determined by money market equilibrium is consistent with the interest rate achieved in the bond market.
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Key Takeaways People hold money in order to buy goods and services transactions demandto have it available for contingencies precautionary demandand in order to avoid possible drops in the value of other assets such as bonds speculative demand. The higher the interest rate, the lower the quantities of money demanded for transactions, for precautionary, and for speculative purposes. The lower the interest rate, the higher the quantities of money demanded for these purposes. The demand for money will change as a result of a change in real GDP, the price level, transfer costs, expectations, or preferences.
We assume that the supply of money is determined by the Fed. The supply curve for money is thus a vertical line. Money market equilibrium occurs at the interest rate at which the quantity of money demanded equals the quantity of money supplied. All other things unchanged, a shift in money demand or supply will lead to a change in the equilibrium interest rate and therefore to changes in the level of real GDP and the price level.
Macro Notes 4: Goods and Money Markets
In the Fed was concerned about the possibility that the United States was moving into an inflationary gap, and it adopted a contractionary monetary policy as a result.
Draw a four-panel graph showing this policy and its expected results. In Panel ause the model of aggregate demand and aggregate supply to illustrate an economy with an inflationary gap. In Panel cshow how it will affect the demand for and supply of money. In Panel dshow how it will affect the exchange rate.
Yet, Fed policy announcements typically focus on what it wants the federal funds rate to be with scant attention to the money supply. Whereas throughout the s, the Fed would announce a target federal funds rate and also indicate an expected change in the money supply, inwhen legislation requiring it to do so expired, it abandoned the practice of setting money supply targets. The factors that have made focusing on the money supply as a policy target difficult for the past 25 years are first banking deregulation in the s followed by financial innovations associated with technological changes—in particular the maturation of electronic payment and transfer mechanisms—thereafter.
Before the s, M1 was a fairly reliable measure of the money people held, primarily for transactions. The Fed could thus use reliable estimates of the money demand curve to predict what the money supply would need to be in order to bring about a certain interest rate in the money market. Legislation in the early s allowed for money market deposit accounts MMDAswhich are essentially interest-bearing savings accounts on which checks can be written.
MMDAs are part of M2. Shortly after, other forms of payments for transactions developed or became more common. Another innovation of the last 20 years is the automatic transfer service ATS that allows consumers to move money between checking and savings accounts at an ATM machine, or online, or through prearranged agreements with their financial institutions.
While we take these methods of payment for granted today, they did not exist before because of restrictive banking legislation and the lack of technological know-how. Indeed, beforebeing able to pay bills from accounts that earned interest was unheard of. Further blurring the lines between M1 and M2 has been the development and growing popularity of what are called retail sweep programs.
Sincebanks have been using retail-sweeping software to dynamically reclassify balances as either checking account balances part of M1 or MMDAs part of M2. They do this to avoid reserve requirements on checking accounts. The software not only moves the funds but also ensures that the bank does not exceed the legal limit of six reclassifications in any month.
In the last 10 years these retail sweeps rose from zero to nearly the size of M1 itself! We need to be very careful with terminology because we want to carefully distinguish between what is happening in the goods markets which describes a flow equilibrium between the production and purchase of real goods and services in a given year and the money market which describes a stock equilibrium between the demand and supply of money holdings and financial assets at a given point in time.
The secret to doing well in this material is using words very carefully.
Demand, Supply, and Equilibrium in the Money Market
The interactions are very straightforward: The money market determines the interest rate. The demand for money in the money market is affected by income which is determined in the goods market. The goods market determines income, which depends on planned investment. Planned investment in turn depends on the interest rate which is determined in the money market.
If something changes in goods markets and affects Y, this in turn will affect Md and hence affect r.
If something changes in money markets and affects r, this in turn will affect Ip, and hence affect Y. Now, finally, we have a theory about why Ip might change. The argument is as follows: Interest rates are not the only thing that determines decisions, but they are the variable we will focus on since they give us the links between the money market and the goods market. Other things being equal, as interest rates rise, it becomes more expensive to finance investment projects.
Thus, as r increases, the number of investment projects planned will decline. This will reduce the level of investment expenditures in the goods market. So Ip increases as r decreases, and Ip decreases as r increases. A more extensive explanation would go like this: If we assume that it can consider each one separately, and attach an expected rate of return to it with confidence, then at an interest rate of ten percent a firm will undertake all the projects that will generate a ten percent rate of return or better, but it will not borrow at ten percent to finance a project that will produce only a nine percent return.
If the interest rate falls to eight percent, though, that project that offered a nine percent return now looks pretty good. So the lower the interest rate, the larger the amount of capital equipment firms will acquire, or the higher will be Ip. Now as Ip increases, aggregate expenditures increase. And, as aggregate expenditures increase, equilibrium Y increases. This works exactly like an increase in G: As output Y rises C rises, which means even more demand for goods, more output, more C, etcetera.
So the multiplier process will produce a larger change in equilibrium Y than the initial increment in Ip. So we have the whole picture in place. When the Fed increases the money supply, it lowers the interest rate. This causes Ip to increase, and thus causes aggregate expenditures to increase. This in turn will set loose our multiplier and cause income to increase. When the Fed reduces the money supply, this causes interest rates to rise, this in turn causes Ip to fall, and thus causes aggregate expenditures to fall.
This is turn will let loose our multiplier process and cause income and employment to decrease. Thus, expansionary monetary policy means that the Fed is either reducing the required reserve ratio, lowering the discount rate, or buying bonds. Any of these policies will increase the money supply, which should reduce interest rates and cause investment, and hence expenditures, and income and employment, to increase. Contractionary monetary policy is when the Fed practices a policy of "tight money.
Any of these policies will reduce the money supply hence "tight money"which will increase the interest rate. This causes investment to fall, which in turn will cause expenditures, income and employment to decrease. We've have looked at how the money markets affect the goods markets, but not examined the reverse in any detail. As Md increases, ceteris paribus, r will increase.
Let us say that the government cut taxes. This will cause Y to increase. As Y increased in the goods market. Md increases, causing r to increase. As a result, Ip will fall. Similarly if Y falls, Md falls. As Md falls, ceteris paribus, r will fall. On the other hand if government spending were cut, the resulting lower Y would reduce Md, and r would fall.
Ip would then rise.