MacroeconomicsI_working_version (1)

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Chapter 13
We can summarise the steps as follows:
R down → M down → i up →I, C, X down → AD down → real GDP down and P down
13.2.2. The Money Market
Let’s remind some facts about money demand and money supply for better understanding
the transmission mechanism. A part of the mechanism refers to changes in interest rates
and credit conditions caused by altering money supply. From Chapter 7 we know, that the
part of demand for money undertaking transactions depends upon income. The other part
of money demand, derived from the need for very liquid and super safe assets, is sensitive
to interest rates – interest yields of other financial assets.
The supply of money is influenced by the banking system including the commercial banks
and the nation’s central bank. The central bank provides reserves to the banking system
through the open-market operations and other monetary policy tools. Commercial banks
then create deposits out of the central-bank reserves. The central bank can control the
money supply by manipulating reserves more or less without some larger deviations.
13.2.3. Supply and Demand for Money
The market interest rate is jointly determined by the supply and demand for money.
The supply and demand for money jointly determine the market interest rate. Figure 13.2
depicts the total quantity of money (M) on the horizontal axis and the nominal interest rate
(i) on the vertical axis. We assume the central bank manipulates its monetary instruments to
control money supply at a given level. That’s why the money supply curve is drawn as
vertical curve equal to level M* in Figure 13.2.
Money demand curve is downward sloping showing the negative relationship between
people’s willingness to hold money and interest rates. With higher interest rates people and
firms prefer the assets bearing higher interest rate (interest yield) rather than no-yield
money.
The interest rates are the prices paid for the use of money. The market interest rate is
determined by the intersection of the supply and demand curves as it is shown in Figure
13.2. The money markets can be defined as the markets where short-term funds are lent
and borrowed.