MAcro CHAPTER 4.5:

CHAPTER SUMMARY

We know that demand curves are always downward sloping. This is even true for the demand for money itself! Interest rates are like the cost of getting money now instead of later, so in a way, they are basically the "price" of money. This helps us understand the demand curve for the money market, which shows that, as interest rates fall, demand for money goes up. When interest rates are very high, though, people will decide that it's not that important to buy something or invest in something now, so the demand for money falls.

Demand for money comes from two purposes:

1. Asset demand for money: People want to hold money because it is a store of value.

2. Transaction demand for money: People want to have money to buy things.

There are several determinants of demand for money - these represent changes in the two types of demand above:

• Price level: If prices rise, people need more money, and demand for money increases.

• Real GDP: If Real GDP rises, more money is being spent, increasing demand for money.

Luckily, the demand curve for money moves exactly like the regular demand curve and the aggregate demand curve, so nothing new here!

The supply of money, though, has no relationship with the interest rate. It is controlled entirely by the Fed, so it is a perfectly inelastic, perfectly vertical line. We find our equilibrium interest rate at the point where the demand curve for money crosses the supply curve for money.

If spending in the economy increases for any reason, we expect to see a rightward shift in the demand curve, raising the equilibrium interest rate (Graph 1). The opposite would happen if spending decreased. If the money supply increases, we would expect to see a lower equilibrium interest rate (Graph 2). This makes sense, because money has become less scarce, but demand for money has not changed, so people should be able to get it more easily. The opposite would happen if the money supply decreased.

This graph really focuses on nominal interest rates in the short-term, in response to changes in the money supply (due to Fed policy) and demand for money. This is important to note when comparing it to the loanable funds market in chapter 4.7.

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