supply of money interest rate the annual rate at which payment is made for the use of money (or...
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Supply of Money
Interest Rate • the annual rate at which payment is made for the
use of money (or borrowed funds)
• a percentage of the borrowed amount
• the price of money
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Supply of Money
The supply of money is determined by the Bank of Canada
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Ra
te o
f in
tere
st
Quantity of money
MSthe supply of money is constant at any one point in time
The Bank of Canada
• Canada’s central bank
• Government owned institution
• Directors and governor are appointed by the federal cabinet
• Current governor Mark Carney
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Functions of the Bank of Canada
• The issuer of currency
• The government’s bank and manager of foreign currency reserves
• The bankers’ bank and lender of last resort
• The auditor and inspector of commercial banks
• The regulator of the money supply
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Demand for MoneyMade up of 2 types of demand:
1. Transactions demand for money– The desire to hold money as a medium of exchange,
that is, to effect transactions– The major determinants are the level of real income
and the level of prices
2. Asset demand for money– The desire to use money as a store of wealth, that is,
to hold money as an asset– The major determinant is the rate of interest
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Transactions Demand
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Transactions demand is unrelated to the
rate of interest
r
Quantity of Money
MDT
r1
r2
Q
Asset Demand
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There is an inverse relationship between asset demand and the
rate of interest
r
Q of Money
r1
Q1
r2
Q2
MDA
Money Demand
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Total demand for money is the sum of transactions demand
+ asset demand
r
Q of Money
MD= MDT+ MDA
MDT
MDA
Demand for Money
Determined by:
1. The level of transactions (real GDP)
2. The average value of transactions (the price level)
3. The rate of interest
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EquilibriumLO1
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Shortage
MS
MD
Q of MQ1
r1
r2
r3
Surplus • At equilibrium interest rate, r1, there is no surplus or shortage of money. • At any other rate there is either a shortage or surplus.
Self-Test 1
a) Assume that the nominal GDP in this economy is $800 and that the transaction demand for money is equal to 10 percent of nominal GDP. Draw in the total demand for money curve.
b) If the money supply is $150 billion, draw in the money supply curve.
c) If the interest rate, is 10 percent, is there a surplus or shortage of money? How much?
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Self-Test 1a) Assume that the nominal GDP in this economy is $800 and
that the transaction demand for money is equal to 10 percent of nominal GDP. Draw in the total demand for money curve.
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Interest rate Asset Demand
($billions)
Transaction Demand
MD
12 50
11 55
10 60
9 65
8 70
7 75
6 80
Self-Test 1
a) Assume that the nominal GDP in this economy is $800 and that the transaction demand for money is equal to 10 percent of nominal GDP. Draw in the total demand for money curve.
b) If the money supply is $150 billion, draw in the money supply curve.
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Q
iS
140 150 160
10%
12%
6% D
Self-Test 1
c) If the interest rate is 10 percent, is there a surplus or shortage of money? How much?
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Q
iS
140 150 160
10%
12%
6% D
How the Money Market Adjusts
–Money markets adjust to a surplus or shortage through bond yields
– People can hold wealth as either money or bonds – Surplus of money: people buy bonds – Shortage of money: people sell bonds
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Bond Yields
Bonds
– Loans for a set period of time – Issued by corporations, banks, and various levels
of government– Have a set face value– Pay a fixed rate of interest (the coupon rate) – Can be bought and sold in the market
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Bond Yields
Bonds:
- The return (“yield”) on a bond depends on:1. the coupon rate 2. the profit or loss on its sale
- Bond prices adjust to reflect return on other financial instruments with similar risk
- The higher the price, the lower the return
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coupon interest +/ change in the bond priceRate of return (rate of interest) = 100
Price paid for bond
Bond Yields
Example: $5000 bond, 4% coupon rate, 1 year
- The higher the price, the lower the yield - The lower the price, the higher the yield
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coupon interest +/ change in the bond priceRate of return (rate of interest) = 100
Price paid for bond
($200 $300)Purchase price: $4700: Rate of return = 100 10.64%
4700($200 $100)
$4900: Rate of return = 100 6.12%4900
($200 $100)$5100: Rate of return = 100 1.96%
5100
How the Money Market Adjusts
Surplus of money
– People choose to buy bonds to reduce their liquidity and earn income
– Bond prices rise, leading to a fall in bond yields and interest rates
– Rates fall until there is no more surplus
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How the Money Market Adjusts
Shortage of money
– People sell bonds in order to increase their liquidity
– Bond prices fall, leading to an increase in bond yields and interest rates
– Rates increase until there is no more shortage
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How the Money Market Adjusts
Increase in interest rate caused by:
– Rise in the demand for money OR– Fall in the supply of money
Decrease in interest rate caused by:
– Fall in the demand for money OR – Rise in the supply of money
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Self-Test 2a) If money supply = $150, what is the equilibrium interest rate?
b) If money supply = $140, what is the equilibrium interest rate?
c) If interest is 11% and MS = $150, what are the implications?
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Interest rate Asset Demand
($billions)
Transaction Demand
MD
12 50 80 130
11 55 80 135
10 60 80 140
9 65 80 145
8 70 80 150
7 75 80 155
6 80 80 160
Self-Test 2a) If money supply = $150, what is the equilibrium interest rate?
b) If money supply = $140, what is the equilibrium interest rate?
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Interest rate Asset Demand
($billions)
Transaction Demand
MD
12 50 80 130
11 55 80 135
10 60 80 140
9 65 80 145
8 70 80 150
7 75 80 155
6 80 80 160
Self-Test 2c) If interest is 11% and MS = $150, what are the implications?
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Interest rate Asset Demand
($billions)
Transaction Demand
MD
12 50 80 130
11 55 80 135
10 60 80 140
9 65 80 145
8 70 80 150
7 75 80 155
6 80 80 160
Self-Test 4Show the effects if the Bank of Canada buys $2 billion worth of securities directly from the commercial banks.
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All Commercial Banks
ASSETS
Reserves:
in vaults $ 70
on deposit at B of C 12
Securities 118
Loans 600
Total assets $ 800
LIABILITIES
Deposits 800
Total liabilities $ 800
Bank of Canada
ASSETS
T-bills and bonds $ 82
Total assets $ 82
LIABILITIES
Notes in circulation $ 65
Deposits of banks 12
Other liabilities 5
Total liabilities $ 82
Self-Test 10
a) If M is $100, P is $2, and Q is 500, what is the velocity of money?
b) Given the same parameters as in a), if the velocity of money stays constant and assuming the economy is at full employment, what will be the level of P if M increases to $120?
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