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The money market
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Money supply and demand impacting interest rates
Video transcript
Now that we know that we
can view interest rates as essentially the price of renting money. I want to go through a bunch of scenarios just so we can understand
how different things that happen in the economy might
effect interest rates. I just draw a bunch of
supply and demand curves right over here. Once
again we're talking about the market for essentially renting money. That right over here
is the price of money, which we know is the interest rate on the vertical axis. Then the
horizontal axis we have the quantity of money
that is borrow or lent in a given time period.
Quantity and this is a given time period that
is borrowed or lent. Quantity borrowed in a
year. We know there is some ... if we just wanted
to draw a demand curve our starting demand curve.
The first few dollars out in the economy
people are willing to pay a very high interest
rate on them. Then every incremental dollar after
that people get less marginal benefit. They
might not find as good of a place to put that
money. Their borrowing it for a reason. Their
either going to borrow to consume to buy
something that they always wanted that they think
will make them happy, or more likely their
borrowing it to invest it and hopefully getting a
return higher than what they are borrowing at. You have a marginal benefit curve that would
be downward sloping something like that.
Maybe it looks something like that. That is our
demand curve or our marginal benefit curve. The supply curve. Now,
once again this is the exact same logic we use
with the demand and supply curve for any good or service. For money might look
like this. Those first few dollars someone has
a very low opportunity cost of lending it out,
so, their willing to lend it out at a very low interest rate. Then every incremental
dollar after that theirs higher opportunity cost,
and people will lend it out at a higher and higher rate. Then you have a market
equilibrium interest rate. Let me copy and paste
this. Then we could think about what happens in different scenarios. Copy and paste. Now we
have 2 scenarios that we can work on, and then let
me just do 1 more. 3 scenarios. Let's think of a couple.
Let's say that the central bank of our country, in the United States, that would be the Federal
Reserve, the central bank prints more money.
Then decides to lend out that money. That
actually is ... in the previous video I talked
about the central bank printing money and then dropping it from helicopters, that is not
how money is actually distributed. It is
disturbed when central banks print money. The way that
it enters into circulation in most countries is that the central bank then goes and essentially
lends that money. The way it's done in the US Fed, most part they go out and buy government securities which is essentially lending money to the Federal Government. They
do that because that's considered to be the safest investment. They go out there and they lend money. If this is our original supply curve. If this is our original
supply curve, but now your Federal ... Central
Bank is printing more money and lending it out.
What is going to happen over here? Your supply
curve is going to shift to the right at any
given price, at any given interest rate. Your going to have a larger quantity of money being
available. It might look something like ... your
new supply curve might look something like that. Assuming that's the
only change that happens you see its effect. Your
new equilibrium price of money, the rent on
money, or the interest rate on money is now
lower. That's why when the Federal Reserves say I
want to lower interest rates, they do so by printing money. They print that money,
and they lend it out in the market. That essentially
has the effect of lowering interest rates. Let's think about another situation. Let's say this is the Fed
prints and lends money. Their lending the money by
buying government bonds. When you buy a government
bond, your essentially lending that money to
the Federal Government . I've done other videos
on that where we go into a little bit more detail on that. Let's think of another situation. Let's think about
consumer savings go down. One interesting thing
about savings, savings and investment are two
opposite sides of the same coin. When you save money
... you literally put it into a bank. You
have the whole financial system right over here.
This is the finincial system. Financial system.
That money goes out and is lent to other people.
For the most part, hopefully, that money
when it's lent is used to invest in someway. This is lending. If consumer savings
goes down that means the supply of money will
be shifted to the left. At any given price and
any given interest rate their be less money available. In this situation our
supply curve is shifting to the left. That would
increase interest rates. Then you could even
make an argument that if consumers savings is
going down consumers are going to borrow less as well. You could argue that maybe demand
would go up as well. Your demand could go
up and that would make the equilibrium interest
rate even even higher. Let's do another scenario.
Let's say that the Federal Government in
an effort to ... let's say that for whatever
reason, their trying to finance a war or some type
of public works project and they don't want to raise taxes. The government decides to
borrow a lot more money. The government is essentially
going expand it's deficit. The government is going to borrow money. Here our supply isn't
changing. I'm assuming the Central Bank isn't
changing it's policies, how much it's printing.
Savings rates aren't changing. The demand is going to go up. Government is borrowing
money. The government is going to borrow more
money than it was already doing. At any given price
the demand for money is going to increase. We're going to shift to the right, and our
new equilibrium interest rate, remember the
rental price of money, is going to go up. The whole point of this
is just to show you that you really can't think
about money like any other good or service. If the
supply of money goes up then the price of
money, which is interest rates, will go down.
Let me write this down. If the supply goes up
then the price, which is just the interest rates goes down. If the demand goes up,
then the price of money will go up. Interest rates will go up. Then we think about all
the other combinations where demand goes down,
then interest would go down. Which is essentially just price. If supply went down,
interest rates would go up. If something becomes
more scarce the price of it goes up. The whole
point of this is just to show that it's not that complicated. You'll see people say,
oh, government borrowing, it's crowding out other
savings, interest rates go up, and it sounds
like something deep is happening. They are just talking about the supply and demand for
money. You just have to remember that interest
rates really are nothing more than the rental price for money.