Question

1- How does money market differ from the lonable funds market?

Which does the Fed have more influence over?

Answer 1

a) Let us first consider money market.The purpose of money market lies in providing liquidity to market participants’. Money is not the same as wealth. Assets like houses are not money. The demand for money is downward slopping because at higher rates of nominal interest, opportunity cost of having money is high, so money demand is low. People demand money for transaction and speculative purposes. Money supply is vertical as the Feds determine it. On the X axis there is the quantity of money and on y axis is the nominal exchange rate.

Money market takes into account the short run only. Due to expansionary monetary policy,from islm , we know real GDP increases. But that is only in short run. They do not take into account inflation or anything related to long run. Hence, the nominal exchage rate is considered here.

Loanable funds markets shows the supply and demand of people for loans. On the vertical axis we have the real exchange rate and on the horizontal axis we have the quantity of loanable funds.

the Demand for funds is the amount of money businesses etc are willing to borrow at a given exchange rate. Supply is the amount of money available to be lend out. The decision to borrow and lend has more to do in long run, not in short run. Therefore here we take the real interest rate, ie nominal exchange rate minus adjusted inflation. Expected inflation affects decisions of borrowing and lending. If expected inflation rises, lenders will charge higher nominal interest rates and borrowers will also accept it. however the real exchange rate will remain same.

Thus the major differences in a nutshell:

Money market is in short run and hence considers nominal exchange rate. Loanable funds market is in long run and hence considers real exchange rate.

b)Feds have more influence over money market. If feds increase money supply, Money supply will shift to the right and in this way Feds can control the nominal interest rate.