MANAGING THE ECONOMY WITH
THE DEMAND FOR MONEY
The interest rate
The interest rate is the opportunity cost of
holding wealth in the form of money rather than
an interest-bearing asset.
Remember money is what doesn’t earn interest,
like cash in your pocket. When you hold cash or
a chequing account, you receive no (or very
little) interest. The interest you could have
earned is the PRICE of holding money.
Just as when the price of a good rises, people
buy less of it, so when the interest rate rises,
the price of money, people hold less of money.
An increase in real GDP increases the volume of
expenditure, which increases the quantity of real
money that people plan to hold.
An increase in real GDP acts like an increase in
income. Real GDP rises, people wish to hold
The effect is fairly strong, because the more
goods and services people are buying, the more
cash you need on hand they need to pay for
them. The cash will be travelling from your
bank account, to the cash register of the store, to
the manufacturer and to the wages or workers
and back to the cash registers of the stores. But
if more goods are being bought and sold, more
cash must be owned by someone as it flows
through the economy.
Financial innovations, such as credit and debit cards and
internet banking, have reduced the need for cash and have
tended to reduce the demand for money. Working for cash
under the table and other illegal activities would increase
the demand for cash
THE SUPPLY OF MONEY
The supply of money is controlled by the Bank
of Canada. The Bank of Canada is run by the
federal government and is responsible for
maintaining stable financial markets, stable
markets for the Canadian dollar and for
controlling inflation and reducing
It can control the total amount of money in the
economy and also control the interest rate.
At any point in time, the money supply of
Canada is fixed in quantity. So the money
supply of Canada is perfectly inelastic with
respect to the interest rate.
(Key diagram to be able to use.)
The interaction of money demand and money
supply sets the interest rate.
If the interest rate is above equilibrium, say 6%,
people will want to hold less money and more
assets that earn interest. They will shift their
cash out of chequing accounts and into short
Firms may put their money for Friday’s payroll
into short term bonds or Treasury bills until
As firms buy bonds and Treasury bills, they
push the price of them up. That pushes the
interest rate down.
As the interest rate falls, firms and people are
more willing to hold cash. The proportion of
people’s assets they are willing to hold as
chequing accounts increases. Equilibrium is
If the interest rate is too low, say 3%, then
people will sell bonds to have the convenience
of cash. The bond prices will rise, and the
interest rate will fall.
BOND PRICES AND INTEREST RATES
A Treasury bill in 30 days pays $10,000.
Their price today depends on the supply and
demand for them.
If a firm buys it today for $9,950, then in 30 days
the firm redeems it for $10,000.
$10,000-$9,950 = $50
$50/$9,950 = .005 or .5% in one month, one half
a percent interest.
(If you have LOTS of money, it is worth the
At an annual rate, that is 12 * .005 = .06 = 6%
If the price of bonds rises, the interest rate
If the bond price rises to $9,975 and is redeemed
in one month for $10,000, then the firm collects
$25/$9,975 = .0025, .25% a quarter of a percent.
At an annual rate, that is 12 * .0025 = .03 = 3%
A big change in interest rate, for a little change
The Bank of Canada can alter the interest
rate by altering the money supply.
They alter the money supply by engaging in
open market operations.
If they buy bonds in the open market
they put money in the system and the
money supply increases and interest
If they sell bonds in the open market
they take money out of in the system
and the money supply decreases and
interest rates rise.
If they increase the money supply, MS shifts
to the right, and the equilibrium interest rate
If they decrease the money supply, MS
shifts to the left, and the equilibrium interest
(shifts in the money supply and changing
interest rates are the most important
INTEREST RATES AND EXPENDITURES
Rising interest rates decrease expenditures
– shift AD in.
Falling interest rates increase expenditures
– shift AD out.
The changes in interest rates work on three
categories of aggregate demand.
1. Consumption expenditures.
If interest rates fall borrowing money to
finance the purchase of consumer durables
is less expensive. Car payments are lower.
Credit card balances are easier to carry.
2. Investment expenditures.
The expected profits from an investment
(less an allowance for risk) must be
greater than the interest rate. The lower
the interest rate, the less profitable the
investment may be and still be attractive
to the firm. Lower interest rates make
firms more willing to undertake
3. net exports
The interest rate alters exports and imports
by changing the exchange rate.
a. If the interest rate falls in Canada
relative to the world, people will sell
Canadian bonds and treasury bills in
order to buy foreign bonds.
b. To buy foreign bonds, they must sell
Canadian dollars and buy foreign
c. The decrease in the demand for
Canadian dollars drives down the price
of Canadian dollars, the exchange rate.
If the interest rate rises, the reverse happens.
foreigners want to buy Canadian bonds, so they buy
the Canadian dollars needed to pay for them,
driving up the exchange rate.
d. The fall in the exchange rate reduces the
cost of exports and increases the cost of
imports. As a result, exports rise and
AD shifts to the right, that is it
MONETARY POLICY AND
If the Bank of Canada believes that there is a
recessionary gap in the economy or about to
appear, it increases the money supply and interest
As a result, Consumption, Investment and Net
Exports increase so that Aggregate Demand shifts
to the right.
Equilibrium income rises, and the economy tends
If an inflationary gap were emerging, the bank
would reduce the money supply and raise interest
Higher interest rates would decrease Consumption,
Investment and Net Exports and result in a shift in
Aggregate Demand to the left, closing any
inflationary gap and removing inflationary
The advantage of monetary policy is that it can be
carried out quickly, and quietly with no need for a
political discussion of changing government
spending, taxes or transfer payments.
The Bank of Canada’s job is to constantly monitor
the Canadian economy and make small continuous
adjustments to keep it near equilibrium.
The disadvantage of monetary policy is that the
process of changing interest rates changing
spending can take a long time and it is hard to be
precisely sure how much aggregate demand will
shift as a result. This problem is a bigger problem,
the further from equilibrium the economy has
Right now, David Dodge is making reductions in
the interest rate to compensate for the decline in
Aggregate demand has declined due to the decline
in exports to the U.S.
Exports have declined because of a recession in
the United States and because of the rise in the
value of the Canadian dollar. The dollar has risen
because people are investing much less in the U.S.
stock market. (Not all changes in the value of the
Canadian dollar are caused by interest rates.)
With good judgement, and doubtless a bit of luck,
he will get just the right amount of increase in the
money supply and decline in the interest rate to
keep up on an even keel. Too much, and AD may
shift too far to the right. Too little, and AD may
shift too far to the left. Goldilocks policy is