Economics - Interest Rates Are Prices

The starting point in any analysis of interest rates is the recognition that they are prices - and as prices the best way to understand them is with the supply and demand tools we learned earlier . We have used the supply - demand model to explain wages, stock prices, and exchange rates and now we will use it to explain the price of money. The graphical version of the Supply - Demand model of the money market appears below.

While we will not embark on an extensive review of the Supply and Demand model of prices, you should review the cookbook approach. The important steps in the approach are:

A schematic of the cookbook approach to the money market appears below. The market is the market for money in which the interaction of suppliers (Fed and banks) and demanders (individuals and firms) determines the price (interest rate). In the remainder of this section we will fill in some of the details concerning the "Players" in the market.

We will begin our analysis of money and interest rates with a treatment of money demand based on the work of Keynes. This will be followed with a discussion of the money supply process which will include a discussion of the Fed, the central bank of the US, and the process of money creation that links the Fed, banks, and the money supply. When we are done you should be able to explain past interest rate movements and / or forecast future interest rate movements.

Why do people want / demand money? As you will recall from our earlier discussion of the Classical economists (1930s), money was traditionally viewed as simply a medium of exchange. Money had no intrinsic value so people demanded money simply to facilitate their transactions - if they had money they would spend it, and if the volume or price of their transactions increased, they would need more money. This transactions demand is described in the Transactions Demand schematic below where more income leads to more transactions which leads to demand for more money.

Keynes, took a somewhat different view of money, a more general view where he specified three reasons for holding money - transactions, precautionary, and speculative motives. The first of these was simply the old Classical view - more transactions means more money demand. It was the last of these that was the real innovation, the Keynesian contribution. Keynes believed money should be viewed as an asset similar to the other assets people own - bonds, stock, and real estate. Furthermore, individuals would be expected to continually alter their portfolio of assets to maximize the expected return. If you read the financial press you will always hear financial gurus telling investors how much of their wealth to keep in stocks, how much in bonds, gold, and cash. Keynes was anticipating this literature.

The logic behind Keynes' speculative demand is simple: if interest rates are low people will not lose much money in foregone interest by holding a portion of their wealth as cash. If you happen to have $1,000 and hold it as cash, then you will be giving up the opportunity to earn $100 when the interest rate is 10%. If the interest rate falls to 5%, then by holding cash you will be giving up the opportunity to earn $50. You would expect as interest rates rise people will tend to hold less of their wealth as money and more as interest earning assets. The "demand" for money will thus be lower at the higher rates, which is what you see in the Speculative Demand schematic below.

If we combine the two effects we will have money demand being dependent on interest rates and the level of transactions, which is assumed to be related to the level of income. Money demand is positively related to the level of income and negatively related to interest rates. The demand for money can be demonstrated with a traditional demand curve that captures the negative relationship between interest rates (price of money) and money demand [Diagram 3]. As the interest rate rises from i* to i**, the demand for money will fall from M* to M**.

This is not the end of the story. Money demand for transactions purposes depends on income and an increase in transactions resulting from an increase in income, possibly the result of the economy moving out of a recession into the expansion phase of the business cycle, will show up as an outward shift in the money demand curve (D to D*).

Now that we have looked at the demand-side of the market, we need to add in the supply side of the market and then put them together to discuss the price of money. We will begin with a simple discussion of the complete model and then shift to a more thorough treatment of the supply-side - one that emphasizes the role of the Fed and banks and the creation of money. For now we will assume that the money supply curve looks like all other supply curves - positively sloped - and that the Fed can move the curve in (decrease money supply) or out (increase money supply).

Let's put yourself in a position to forecast interest rate movements. What will happen to rates if the economy heats up as it begins to move out of a recession and into the expansion phase of the business cycle? What happens if the Fed decides to increase the money supply? An expanding economy means higher production (GDP) which translates into higher incomes. This shows up as an outward shift in money demand - people want to spend more so they need more money. The result, seen in the left-side graph in Diagram 5, is an increase in interest rates. If the Fed increases the money supply, using tools we will discuss in the next section, the money supply curve shifts out as in the right-side graph. The result will be a decrease in interest rates.

Once we have accepted the fact that interest rates are prices, we can make generalizations concerning of the impact of external shocks on these rates. For any shock that can be translated into a shift in the supply or demand curve, the impact on price (interest rates) and quantity (money) can be forecast using the table below which is simply a restatement of what we saw earlier in the analysis of supply and demand.

	Interest Rate	Money Supply
Increase Demand	UP	UP
Decrease Demand	DOWN	DOWN
Increase Supply	DOWN	UP
Decrease Supply	UP	DOWN

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