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Macroeconomics: the money market and loanable funds market

 

The money market:

  • The money market combines the supply of money and the demand for money for a country.
    • The supply curve (Sm) is inelastic and is determined by the central bank.
    • The demand curve (Dm) is the horizontal summation of the asset and transaction demand curves and is sloping downward.
    • The intersection between the Sm and Dm is the equilibrium interest rate for a country.

  • A change in the nominal interest rate implies that either or both curves (i.e Sm and Dm) have shifted to the right or left.
    • An increase in nominal GDP (P*Y) will lead to an increase in the transaction demand for money which will shift the total demand (Dm) to the right. The nominal interest rate goes up.

    • A decrease in the level of output (Y) will shift the Dm curve to the left.
  • The Sm curve will shift whenever the central bank decides to change the money supply due to a monetary policy decision.
    • The Fed expands the supply of excess reserves in commercial banks, by purchasing bonds from banks, Sm shifts to the right. The nominal interest rate (i) goes down.

    • When the Fed reduces the excess reserves by selling government bonds to commercial banks (i.e reducing the level of liquidity in the system) the Sm shifts to the left, the nominal interest rate at equilibrium goes up.
Loanable funds market:
  • Investment demand is inversely related to the real interest rate (r)
    • assuming that the expected inflation does not change, then an increase in the nominal interest rate (i) will increase the real interest rate(r). 
    • Assuming i stays constant if inflation (denoted by pi) is expected to increase, the r goes down.

  • A change in either inflation or nominal interest rate will cause a movement along the demand curve for investment (changing the quantity of funds demanded for investment). 
  • If a monetary policy reduces the supply of money, this will lead to a reduction of funds demanded for investment which will shift the aggregate demand curve to the left in the AD/AS model which causes a reduction in real output (Y) and a downward pressure on the price level (i.e deflation). This is known as a contractionary monetary policy. 
  • An expansionary monetary policy is one which increases the money supply which causes an increase in the quantity of funds for investments, causing the AD curve to shift to the right, increasing Y and putting upward pressure on the price level (i.e inflation). 
Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 162-167.

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