EC212 · LESSON 05 / 08

5. Money and interest rates

Holding money makes purchases easy but forgoes interest. Income and interest rates therefore affect money demand.

Understand

What is this lesson explaining?

Money demand rises with income because transactions increase, but falls with interest because the opportunity cost rises. M/P is the real purchasing power of money balances. Equilibrium equates real supply and real demand.

In a model where the central bank controls M, bond purchases raise money supply. With fixed P, M/P rises; people try to buy interest-bearing assets, raising bond prices and lowering yields.

KEY MODEL

M/P = L(Y,i) = kY − hi

M, PNominal money supply and price levelL, k, hReal money demand and its positive income/interest sensitivity coefficientsiNominal interest rate, in the problem’s stated units

See it on a graph

The graph is right here

Read the axes and original point first. Then change one value at a time and watch the curve or point move.

More money lowers the equilibrium interest rateHolding real money demand and the price level fixed

Quick check

NO TYPING

If P rises with M and Y fixed, what happens to i in the basic money market?

Takeaway

Remember these two ideas

✓

With M/P = 100, Y = 400, k = 0.5, and h = 20, 100 = 200 − 20i, so i = 5%.

Common mix-upDemand to hold money is not demand to borrow. Bond prices and yields move inversely for fixed promised payments.

Assumptions and sources

The standalone money-market calculation fixes Y and P. When rates use percentage-point units, i = 4 means 4%.

EC212 tutoring outline: chapters 1–8 (local course outline)
Mankiw, Macroeconomics, 8th edition, chapter 11, p. 318; chapter 4, monetary instruments