Money, Banking, Monetary Policy (Interest Rates) amazonaws com
Money, Banking, Monetary Policy (Interest Rates) The Transmission Mechanism Money supply (MS) and Money Demand (MD) determine the interest rate Interest rate affects aggregate demand MS (currency + bank deposits) is determined by: o Central bank (bank of Canada), which determines bank reserves (we will study next) o Commercial banks, via multiple deposit creation What determines MD? The Demand for Money: Intuition Households hold two assets o Money (currency + bank deposits): pays no interest o Bonds: pay interest Example: You have Money $1000 Bonds $10000 Would you increase or reduce money holdings if: The interest rate rises from 5% to 10% reduce Your income rises, so you will be spending more on goods and services? increase Prices in the economy increase, so you will have to pay more for the same goods and services you plan to purchase? increase
Demand for Money Result 1) Falls as interest rate increases 2) Rises as real GDP increases 3) Rises (proportionately) as price level increases Reason 1) Money does not pay interest Opportunity cost (interest foregone) of holding money increases 2) Real volume of transactions increases 3) Dollar volume of transactions increases (need more money for same transactions) Diagram #1 & 2
Money supply (MS) is determined by bank of Canada (and, thus, is perfectly inelastic) Note: bank of Canada recognizes- and takes into consideration- the role of multiple deposit creation by banks Remember: bond prices fall (the present value of a fixed stream of payments declines) as the interest rate increases Diagram # 2: At r1: MS > MD agents try to reduce money holding and to purchase bonds bond prices interest rate goes At r2: MD > MS agents try to increase money holdings and to sell bonds bond prices interest rates At ro: MD = MS no change in interest rate (equilibrium) Observation MS is perfectly inelastic o If MD and MS are not equal, then interest rate changes and MD adjusts until MD = MS (MS is fixed, so if initially not in equilibrium, the interest rate is set in motion and that influences change in MD so adjusts) Example: bank of Canada increases money supply Diagram # 3
Bank of Canada (B/C) Conducts Monetary Policy Transmission Mechanism Expansionary Policy to lower unemployment Money Supply [M’] Interest rate [r] … 1) Household increase expenditures on automobiles, durable goods 2) Firms increase expenditure on plant and equipment Ado shifts right to AD1 Exchange rates: reading assignment (pg 898-909) Concepts 1) DD and SS for Canadian dollar 2) How events cause DD or SS for Canadian dollars to change Examples: how will the foreign exchange value of the Canadian dollar change if: The demand by Canadians for imported shirts from Mexico increases? The demand by china for Canadian oil falls, as growth in china slows? Interest rates in the US fall, while the interest rates in Canada are unchanged? Russian investors decide to develop oil fields in Alberta?
Demand for Money Result 1) Falls as interest rate increases 2) Rises as real GDP increases 3) Rises (proportionately) as price level increases Reason 1) Money does not pay interest Opportunity cost (interest foregone) of holding money increases 2) Real volume of transactions increases 3) Dollar volume of transactions increases (need more money for same transactions) Diagram #1 & 2
Money supply (MS) is determined by bank of Canada (and, thus, is perfectly inelastic) Note: bank of Canada recognizes- and takes into consideration- the role of multiple deposit creation by banks Remember: bond prices fall (the present value of a fixed stream of payments declines) as the interest rate increases Diagram # 2: At r1: MS > MD agents try to reduce money holding and to purchase bonds bond prices interest rate goes At r2: MD > MS agents try to increase money holdings and to sell bonds bond prices interest rates At ro: MD = MS no change in interest rate (equilibrium) Observation MS is perfectly inelastic o If MD and MS are not equal, then interest rate changes and MD adjusts until MD = MS (MS is fixed, so if initially not in equilibrium, the interest rate is set in motion and that influences change in MD so adjusts) Example: bank of Canada increases money supply Diagram # 3
Bank of Canada (B/C) Conducts Monetary Policy Transmission Mechanism Expansionary Policy to lower unemployment Money Supply [M’] Interest rate [r] … 1) Household increase expenditures on automobiles, durable goods 2) Firms increase expenditure on plant and equipment Ado shifts right to AD1 Exchange rates: reading assignment (pg 898-909) Concepts 1) DD and SS for Canadian dollar 2) How events cause DD or SS for Canadian dollars to change Examples: how will the foreign exchange value of the Canadian dollar change if: The demand by Canadians for imported shirts from Mexico increases? The demand by china for Canadian oil falls, as growth in china slows? Interest rates in the US fall, while the interest rates in Canada are unchanged? Russian investors decide to develop oil fields in Alberta?
