 Okay, so we have examined how in the short run we determine equilibrium in the economy by focusing on the demand side. We organize the economy in different markets, the goods market, the financial market, and then we determine equilibrium conditions in those markets so that in the end we can have the overall equilibrium, having brought in the supply side, looking at the labor market and production. For now we're going to focus on the determination of equilibrium in the financial markets. I want to first of all to be useful to clarify a few concepts that we're going to use in this segment. One is money. What do we mean, what do we understand by money? In this segment what we understand by money is liquidity, which means currency, bank notes, coins, but also checkable deposits, checks, travelers checks. The means that you can use readily to settle transactions, that's what we call money. But there is also a similar, I mean, related concepts which are not the same, one is wealth. Wealth is not the same as money. Money is one of the elements of wealth because in wealth you have liquidity, which is money, but you also have non-liquid assets, your bonds, your stocks, and also your non-financial assets, real estate, and so on. So wealth is a broader concept than money. How about income? We understand income as the revenue which is generated from utilizing our capital, whether it is our human capital or our financial capital. When you go to work you generate your labor income. When you invest in assets you also get interest income, but it's the income that allows you to buy assets to accumulate wealth. So income comes from the utilization of your capital to build up wealth, and once you have wealth there are different ways of holding wealth, one being money. So wealth is a bigger concept than money, which is a subset of wealth, and the other subset is bonds, and then you have other. So what now do we mean by demand for money? If I was to ask you what is your demand for money? What does it mean? In this course what we mean by demand for money is when we say what is your demand for money, we try to understand how much of your wealth do you hold here, as opposed to say here, how much cash every week, every month do you keep relative to the other ways in which you could have kept your wealth. So when we say demand for money, it means the fraction of your wealth that you keep in cash. So what is the fraction of wealth held in liquid form? That's what we mean by demand for money. Now the question is what are the determinants or the motivations for holding money? The reason this question is interesting to ask is, or at least is not trivial, is that if you keep $100 here as money, how much are you earning? No interest. You earn no interest. In fact you are losing money because as you are not earning interest, inflation is going up, price levels are going up. So every month you lose the equivalent of the inflation rate. So it's costly for you to keep money here, to keep your wealth here. That's why we ask, why are you keeping money? So there must be a motivation why you would want to sacrifice returns from investment by keeping your wealth in the form of liquidity. One motivation for money demand is transactions. When you go to the store and you're buying groceries and clothing, you need to settle those with some form of means of payment. And universally cash, liquidity is the best means of settling payments. And a check issue gives liquidity. So one of the reasons why we hold money is because we want to, we need it to settle transactions. So it's the best means of payment. Now of course it will depend on your income. The more income you have, the more cash you'll keep in your money box here. Certainly people with lower income are going to have less cash than people with higher income because they consume less. But this is also going to be influenced by the price level. Because if you live in an area where the cost of living is high, then you must keep a larger fraction of your wealth in cash. So that's the first motivation. The second is we never know what the future holds for us. So for precaution, we need to keep some cash at hand. Because if you were to put everything in bonds and real estate and so on, and then you need to go to the grocery store or you need to go to the hospital, you will have difficulty converting all these non-liquid assets into cash for you to settle your payments. So because the future is uncertain, we tend to keep some of the wealth in cash. Of course, the more income you have, the more you keep, but also it depends on expected prices. The last reason for why people hold cash is for speculation. What do we mean by speculation? What we mean by speculation is trying to move your wealth or your assets between one form and another so you can get interest income. Now people will buy a particular move their wealth from say money to bonds if they expect to make money out of bonds. So it's important to understand why would one put their money into bonds. So let's focus on the four concepts or yield. When you buy a bond, you are counting on making money out of the bond. The bond comes with a face value, but today you're going to pay a price to buy the bond. At the end of the term, if it is a one-year bond, a five-year bond, at the end of the life of the bond, you're going to get income, which we call capital gains or yield, capital gains on the instrument, which is the difference between the face value and the price you paid today. So that is the yield. So the yield is the difference between the face value of the bond minus and the price of the bond divided by the bond price. You can see that since the face value is given, if it is a $100 bond, it will be $100. You will get $100. You will not get $110. So if you pay a high price for this bond today in the market, then you get less at the end of the life of the bond. We can rewrite this equation to express the price of the bond in terms of the yield, which gives you... So the price of the bond today is equal to the face value divided by one plus the yield. And you can see already that if the yield is low, the price is high. If the yield is high, the price is low. If the price is high, the yield is low. If the price is low, the yield is high. So you have a negative relationship between the price of the bond and the yield. So I should say a low yield means a high price. A high yield means a low price. So now let's go back to the decision to hold money. If you're going to decide to put some of your worth in as cash, to hold it as cash, as money, that means you are foregoing the earnings you could have made by putting that worth in the form of bonds as opposed to cash. So there is an opportunity cost of holding money. And that opportunity cost is higher, the higher the yield. So we expect that if the interest, if the yield in the bond market is high, we expect people to hold less cash. So money demand is going to be lower. Because with a high yield or low price of the bond, if the bond prices are lower, you would be much better off by investing in the bond, putting some money in the bond, so you can collect the high yields. Alternatively, if the price of the bond is higher, then you don't want to put your money in the bond market. You might as well keep it in cash. So a lower interest rate will result in higher money demand. Just because of this trade-off between earning money on your investments in bonds and keeping money at hand for it so you can be able to settle the transactions. Again, keeping your wealth in cash is costly. You forgot the returns. But also keeping your money in bonds is not free because you forgot the advantages and the use of the money as a means of settling your payments. So that means that when we look at the relationship between money and an interest rate, or yields, we're going to see that there is a negative relationship. High yield, lower money demand. Low yield, higher money demand. So if we're thinking about a relationship between the two, it will be represented by a downward-sloping curve. So this is your money demand. This is holding other things constant such as income. We would see that a high interest rate here would correspond to a low money demand, whereas a lower interest rate would correspond to a high money demand. This is very important for us because then we can determine the equilibrium. So we saw that money demand is going to be a function of, is influenced by interest rate, but it's also influenced by income. I say that the higher the income you have, the more you can afford to keep your wealth in cash. You have more means to hold cash. So if we were thinking about money demand, which is m, let's call it d, but let's think of the real value of money demand, which is md over p. This is p is the price level. How much can you buy with your money? So the two key factors that we saw that influence the amount of money you're going to hold in cash, the amount of wealth you're going to hold in cash, which is money demand, is how much income you have. The other one is what is the yield on bonds in the market? How much do you make by investing in the market versus holding cash? That's the interest rate. So money demand is going to be a function of income and interest rate. So if we hold income constant, or for a given amount of income, the relationship is such that high interest rate corresponds to lower money demand, low interest rate corresponds to higher money demand. So there is a negative relationship between money demand and interest rate. This is convenient in determining equilibrium in the money market, as in all markets, equilibrium is going to be determined by supply and demand. Money is demanded by the public, households, and firms. Supply of money comes from the monetary policy authority. It's exogenous. The central bank determines how much money is circulating in the economy. So once we have money supply by the central bank and money demand by the public, we can determine equilibrium. And given that money supply is not influenced by the public, we're going to take it as exogenous from outside of the system by the central bank. So equilibrium is going to be determined by money demand equals money supply. So in our diagram, we have money demand here and money supply here that gives us the equilibrium interest rate. So equilibrium in the money market is determined by money demand by the public, money supply by the Federal Reserve Bank, the central bank, which gives us equilibrium interest rate. This gives you a sense of how in the financial market we come to determine equilibrium in that market by focusing only on the money market, even though there are other assets. Because once you have equilibrium in one market, you will have or you must have equilibrium in the other markets. Thank you.