The Demand for Money

• The price of holding money balances is the interest rate.

• The interest rate is the opportunity cost of holding money.

• As the interest rate increases, the opportunity cost of holding money increases, and people choose to hold less money.

Supply and Demand for Money

Equilibrium in the Money Supply

• The money supply is not exclusively determined by the Fed because both the banks and the public are important players the money supply process.

• Equilibrium in the money market exists when the quantity demanded of money equals the quantity supplied.

Transmission Mechanisms

The impact that changes in the money market have on the goods and services market and whether that impact is direct or indirect; and the routes and ripple effects created in the money market travel to affect the goods and services market are known as the transmission mechanism.

The Keynesian Transmission Mechanism

• The Money Market• The Investment Goods Market• The Goods and Services Market (AD-AS

Framework)• When the money supply increases, the Keynesian

transmission mechanism works as follows: an increase in the money supply lowers the interest rate, which causes investment to rise and the AD curve to shift rightward. Real GDP increases and the unemployment rate drops.

The Keynesian Transmission Mechanism: Indirect

The Keynesian Mechanism May Get Blocked

• Some Keynesian economists believe that investment is not always responsive to interest rates. The Keynesian transmission mechanism would be short-circuited in the investment goods market, and the link between the money market and the goods and services market would be broken.

• Keynesians have sometimes argued that the demand curve for money could become horizontal at some low interest rate. This is called the Liquidity Trap.

Keynesian Transmission Mechanisms

Because the Keynesian transmission mechanism is indirect, both interest insensitive investment demand and the liquidity trap may occur.

The Keynesian View of Monetary Policy

Bond Prices and Interest Rates

• As the price of a bond decreases, the actual interest rate return, or simply the interest rate, increases.

• The market interest rate is inversely related to the price of old or existing bonds.

• Consider the Liquidity Trap: the reason an increase in the money supply does not result in an excess supply of money at a low interest rate is that individuals believe bond prices are so high that an investment in bonds is likely to turn out to be a bad deal.