Money market and interest rates

The Transmission Mechanisms

• The money and goods markets are linked together
• How are interest rates determined?
• What is the overall effect of these transmission mechanisms on national output?
• The transmission mechanisms are the interest rate and the exchange rate

The money market

• Interest rates are determined in the money market
• The money and goods markets are linked and have effects on each other

Supply of Money

• The horizontal axis represents the quantity of money (M).
• The vertical axis represents the rate of interest (r).
• An exogenous money supply is when the central bank determines money supply, rendering it vertical in this space.
• Money supply (Ms) is an upward-sloping curve because individual banks have some control over the money supply.

Money Supply

• Bank deposits are the largest component of broad money (M4)
• M4 includes cash, deposits in banks, and building societies.
• Banks create money through lending, such as overdrafts or loans.
• If a bank deposits £10 and must hold 10% as cash:
  • £1 is held as cash, and £9 is loaned.
  • If the customer spends £9 at a shop and the shop deposits it, £0.9 is held as cash, and £8.1 is loaned, continuing the cycle.
  • Total money supply expands to £100.
  • Deposit multiplier is 10 (inverse of the cash/liquidity ratio).
• Consideration of what happens if banks lack approved borrowers arises.

The Demand for Money

• L represents liquidity preference and shows households demand for "liquid" assets
• The demand for money L is downward-sloping because the demand for liquid assets such as cash decreases when interest rate r increases.

Supply and Demand for Money

• Higher income leads to higher transactions and more demand for money to support these transactions.
• When disposable income increases, money demand shifts to the right, increasing the interest rate.
• Considerations are made about what happened to the demand for money during the Covid-19 pandemic.

The Central Bank

• If a central bank injects cash into the economy, the money supply shifts to the right, decreasing the interest rate.
• Considerations of what happens to money supply are required when banks hold less money or lower the liquidity ratio.

Transmission Mechanisms

• Discussions cover equilibrium in the goods market using AS/AD (Aggregate Supply/Aggregate Demand).
• Equilibrium involves injections/withdrawals and income/expenditure.
• Equilibrium in the money market.
• The interest rate transmission mechanism and the exchange rate transmission mechanism is mentioned.
• Markets connect through the interest rate and exchange rate mechanisms.

Interest Rate Transmission

• A rise in the money supply is considered by the impact on national output.
• It reduces interest rates and borrowing costs

Increase in Money Supply

• Lower interest boosts investments and increases consumption
• Further investments boost through the accelerator effect
• Results in increased injections into the economy
• Injection curve shifts up
• Reduces the exchange rate cutting savings and imports which reduces withdrawals
• Withdrawals curve shifts from W to W'

Effects of Money Supply

• An increase in the money supply works through various mechanisms, leading to a multiple rise in national output (multiplier effect).
• This increased supply boosts economic growth, cuts unemployment, and raises inflation.
• Effects of a falling money supply requires consideration

Shifting National Output

• The size of the shift in national output hinges on how responsive investment and saving are to interest rate changes
• It hinges on how responsive exports and imports are to exchange rate changes
• Multiplier effect has an influence

IS and LM Curves

• The IS curve illustrates the equilibrium in the goods market, balancing investment and savings.
• The LM curve reflects equilibrium in the money market, balancing liquidity preference and money supply.

The ISLM Model

• The goods market does not include interest rates on one of the axis
• The money market does not include national output on one of the axis
• The good and money markets are linked
• There are several diagrams to work out an interest rate's effect on Investment, Exchange Rate, Exports and National Output
• ISLM brings both markets into one simple diagram
• The investment equals savings and this equals the IS
• LM stands for liquidity of money and this represents the money market

IS Curve

• It displays interest rate and national output combinations in goods market equilibrium.
• The goods market is in equilibrium when Y (output) equals E (expenditure), J (injections) equals W (withdrawals)
• I + G + X = S + T + M (Investment + Government Spending + Exports = Savings + Taxes + Imports).
• The IS curve focuses on I (Investment) and S (Savings).
• T, M, G, and X are constant.

Deriving the IS Curve

• Initial interest rate is r1.
• Investment function I1 and injection function J1 are added, along with the savings function S1
• Constant nature of other injection and withdrawal variables.
• Y1 is the equilibrium for r1 with an r-Y combination.
• A lower interest rate, r2, is a lower investment rate
• The investment function shifts up from I1 to I2 and the savings function shifts right from S1 to S2.
• New equilibrium point (Y2) is associated with r2.
• IS curve is derived by joining points 1 and 2.
• Downward sloping in this space since national output is higher the lower the interest rate

LM Curve

• The LM curve shows combinations of interest rate and national output at which the money market is in equilibrium
• The money market is in equilibrium when demand and supply of money is equal

Deriving the LM Curve

• Initial national output is Y1 with interest rate r1
• National Output increases from Y1 to Y2
• Point 2 shows where the money market is in equilibrium
• Upward sloping as the higher the interest rate the higher the output

IS-LM Model and Analysis

• How equilibrium the IS-LM model are combined to produce macroeconomic policies

The IS-LM Model

• One market can spill over into another as identified in the transmission mechanism analysis
• IS=LM model analyses both goods and money market into one diagram
• The IS model puts IS and LM together and a diagram is shown for each stage of the analysis
• Different diagrams can trace the effects of interest rates and money supply

IS-LM Model

• The IS curve presents combinations of interest rate and national output where the goods market is in equilibrium.
• LM curve shows combinations of interest rate and national output at which the money market is in equilibrium.
• Intersection of IS and LM curves marks equilibrium interest rate (r*) and national output (Y*).
• Suppose output is at Y1 on the LM curve, and interest is at r1 when the money market is in equilibrium
• Goods market not in equilibrium
• It goes through a process until equilibriums are reached in both markets

The ISLM Analysis

• Considers Quantitative Easing
• Central banks buy assets and the supply of money increases
• Long term government debt prices increase and reduce interest rates
• A certain asset worth £100 pays a certain dividend of £10 and if interest rates fall 10% or 5% the price of the asset will increase to £200
• LM model has shifts to the right where the money supply increases.
• Equilibrium Interest Rate: The equilibrium rate goes down from r* to r**. Higher Investment and Consumption: This interest rate level then generates a higher level of both investment, as well as of consumption.
• The rate increase leads to a lower exchange rate, as exports rise and imports decline. National Output Increase: At all outputs, the national output is expected to be higher, going from Y* to Y**.

Effectiveness of Policies

• An injection of government spending shifts the IS curve and if its financed by borrowing from a bank, national output and interest rates are higher.
• Government spending that is not financed by increased taxation results in higher national output and interest rate at the new equilibrium
• An increased money supply shifting the LM curve means national output raises, however, the interest rate won't raise
• Combining both government spending and money supply creates best situation in raising national output