ACC 818 — Module 11: Money, Interest Rates & Economic Activity
How the money market sets interest rates, and how those rates connect (the “transmission mechanism”) to real economic activity.
Learning Outcomes
- Demonstrate understanding of bonds and present value
- Understand reasons for holding money
- Assess determinants of money demand
- Explore monetary equilibrium and national income
- Summarize the monetary transmission mechanism (closed and open economy)
- Show how monetary policy effectiveness depends on the slopes of MD and ID curves
- Contrast Keynesian and monetarist views
Topic 1: Open Market Operations
The most-used monetary policy tool. The central bank buys or sells government bonds to adjust:
- Bank reserves
- The level of interest rates (specifically the overnight rate)
Buying bonds → cash flows from BoC to banks → money supply ↑ → interest rates ↓. Selling bonds → cash flows from banks to BoC → money supply ↓ → interest rates ↑.
The federal funds rate (in the US) / overnight rate (in Canada) is the rate banks charge each other for very short loans. It’s the rate the central bank targets directly.
Topic 2: The Demand for Money
Three motives for holding money rather than other assets:
- Transactions demand — cash to pay for everyday purchases.
- Precautionary demand — cash for unforeseen needs (medical, repairs).
- Speculative demand — cash held in anticipation of better future bond prices.
In practice you can’t tell which motive a given dollar in someone’s checking account is satisfying — the categories are analytical, not observable.
Why money demand slopes downward in interest rates: The interest rate is the opportunity cost of holding money (the bond yield you forgo).
- Rates ↑ → holding cash is more expensive → people hold less → MD slopes downward.
- Rates ↓ → cheap to hold money → people hold more.
Topic 3: Other Determinants of Money Demand
Shifters of the money demand curve:
- Real GDP / income ↑ → more transactions → MD shifts right.
- Price level ↑ → need more money for the same basket → MD shifts right.
- Expectations of bond price changes — expected fall in bond prices → hold money instead → MD shifts right.
- Preferences — cultural or behavioural variation in cash holding.
The Monetary Transmission Mechanism
How a change in money supply propagates to real GDP:
Closed economy: ΔMoney supply → ΔInterest rate → ΔInvestment (and durable consumption) → ΔAD → ΔReal GDP
Open economy adds a second channel: ΔInterest rate → ΔExchange rate → ΔNet exports → ΔAD
This means in an open economy like Canada, monetary policy has two transmission channels (interest rate and exchange rate), making it more powerful but also more complicated.
Bonds and Present Value
Bond prices and interest rates move inversely. When rates rise, the fixed coupon payments on existing bonds become relatively less attractive, so their market price falls. The present value of a future cash flow is discounted by the current interest rate.
Key Terms
Open Market Operations · Overnight Rate · Money Demand · Transactions / Precautionary / Speculative Demand · Liquidity Preference · Monetary Transmission Mechanism · Present Value · Bond Yield