The readings indicate that as interest rates increase institutions/individuals desire to hold less cash money. Instead they purchase interest bearing assets because the opportunity cost becomes too high not to purchase interest bearing assets. Later, the the reading says that when the Fed sells securitities in open market transactions, thereby reducing the money supply and increasing interest rates, institutions/individuals will sell securities to increase their cash balances. This makes sense but seems to contradict the first point that at higher interest rates people hold less cash. Could someone clarify the situation?
When the fed sells securities, institutions/individuals BUY securities. Money leaves the economy, nominal interest rates go up, institutions/individuals hold less cash.
I understand this process but I don’t understand how you determine the net effect of the Feds actions, given that the reduced supply of money will also induce people to sell securities to increase their cash balances.
Some hopefully accurate observations about why institutions/individuals would sell their securities: 1) provide liquidity for the purchase of securities from the Fed 2) make cash available to loan at higher interest rates following the open-market ops. 3) following an increase in interest rates, outstanding fixed income securities would decrease in value and so it may be desirable to exit these positions and re-lend at higher rates It seems the institutional/individual sales of securities you’ve described occurs during the open market operations, rather than afterwards when nominal rates have risen and as you’ve pointed out, the opportunity cost of holding cash increases. Anyway, I’d value input from others.
institutions/individuals will only sell securities to raise cash if given a reason to do so… if they expect interest rates to continue to rise, or if they expect inflation to rise (and thus interest rates), or if they need cash for some personal reasons. The net effect of higher interest rates will, all other things constant, decrease money supply.