A financial portfolio is a mixed holding of money and other financial assets, such as bonds and equities, structured, to balance expected return and risk.
The price of a financial asset like a bond that promises to make future payments is the present value of those payments. Because current interest rates are used to discount future payments and determine this present value, bond prices and interest rates are inversely related.
The demand for money (L) is a demand for real money balances measured in terms of purchasing power over goods and services. It arises from the portfolio decisions people make about the form in which to hold their wealth. Holding money reduces the costs of making both routine and unexpected transactions. It also provides a safe asset, with a fixed nominal price, as a store of wealth. The cost of holding money is the interest income and potential capital gain sacrificed by not holding bonds.
The quantity of real money demanded rises with real incomes, to finance higher transactions, and falls with higher nominal interest rates, the opportunity cost of holding money instead of bonds. The demand for money function is \(L = kY − hi\).
The interest rate (i), is determined by supply and demand in the money market, together with supply and demand in the bond market. As people adjust the holdings of bonds and money in their wealth portfolios, bond prices and yields adjust to clear both bond and money markets simultaneously.
Interest rates play a key role in the transmission mechanism that links money and financial markets to aggregate expenditure.
Household consumption expenditure and business investment expenditure are dependent, in part, on interest rates. A higher interest rate reduces household wealth and increases the finance costs of borrowing. Lower wealth and higher finance costs reduce planned autonomous consumption, shifting the consumption function down. Lower interest rates have the opposite effect.
Changes in interest rates lead to changes in exchange rates that change net exports. The international sector makes an additional link between money, interest rates, and expenditure.
The monetary transmission mechanism links changes in money supply to changes in aggregate expenditure, aggregate demand, and output through interest rates and exchange rates.