Download The Equilibrium Interest Rate

PRINCIPLES OF
MACROECONOMICS
PART III The Core of Macroeconomic Theory
TENTH EDITION
CASE FAIR OSTER
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Prepared by: Fernando Quijano & Shelly
1 ofTefft
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PART III The Core of Macroeconomic Theory
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Money Demand and
the Equilibrium
Interest Rate
11
CHAPTER OUTLINE
Interest Rates and Bond Prices
The Demand for Money
The Transaction Motive
The Speculation Motive
The Total Demand for Money
The Effect of Nominal Income on the Demand for Money
PART III The Core of Macroeconomic Theory
The Equilibrium Interest Rate
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Supply and Demand in the Money Market
Changing the Money Supply to Affect the Interest Rate
Increases in P • Y and Shifts in the Money Demand Curve
Zero Interest Rate Bound
Looking Ahead: The Federal Reserve and Monetary
Policy
Appendix A: The Various Interest Rates in the U.S.
Economy
Appendix B: The Demand for Money: A Numerical
Example
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Interest Rates and Bond Prices
interest The fee that borrowers pay to lenders for the use of their funds.
Firms and governments borrow funds by issuing bonds, and they pay interest
to the lenders that purchase the bonds.
PART III The Core of Macroeconomic Theory
When interest rates rise, the prices of existing bonds fall.
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EC ON OMIC S IN PRACTICE
Professor Serebryakov Makes an Economic Error
PART III The Core of Macroeconomic Theory
In Chekhov’s play Uncle
Vanya, Alexander
Vladimirovitch Serebryakov, a
retired professor, but
apparently not of economics,
calls his household together
to propose the following:
…Our estate yields on an
average not more than two
per cent, on its capital value. I
propose to sell it. If we invest
the money in suitable securities, we should get from four to five per cent, and
I think we might even have a few thousand roubles to spare…
Uncle Vanya tried to kill Professor Serebryakov for this idea, but no one
pointed out that this was bad economics and not a scheme.
Perhaps had Uncle Vanya taken an introductory economics course and
known this, he would have been less agitated.
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The Demand for Money
When we speak of the demand for money, we are concerned with how much of
your financial assets you want to hold in the form of money, which does not
earn interest, versus how much you want to hold in interest-bearing securities
such as bonds.
PART III The Core of Macroeconomic Theory
The Transaction Motive
transaction motive The main reason that people hold money—to
buy things.
nonsynchronization of income and spending The mismatch
between the timing of money inflow to the household and the timing of
money outflow for household expenses.
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The Demand for Money
PART III The Core of Macroeconomic Theory
The Transaction Motive
 FIGURE 11.1 The Nonsynchronization of Income and Spending
Income arrives only once a month, but spending takes place continuously.
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The Demand for Money
PART III The Core of Macroeconomic Theory
The Transaction Motive
 FIGURE 11.2 Jim’s Monthly Checking Account Balances: Strategy 1
Jim could decide to deposit his entire paycheck ($1,200) into his checking account
at the start of the month and run his balance down to zero by the end of the month.
In this case, his average balance would be $600.
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PART III The Core of Macroeconomic Theory
Jim receives $1,200 per month (30 days) and spends $40 each
day. What is his average money balance?
a.
$40.
b.
$30.
c.
$600.
d.
$1,200.
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PART III The Core of Macroeconomic Theory
Jim receives $1,200 per month (30 days) and spends $40 each
day. What is his average money balance?
a.
$40.
b.
$30.
c.
$600.
d.
$1,200.
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The Demand for Money
 FIGURE 11.3 Jim’s Monthly Checking Account Balances: Strategy 2
Jim could also choose to put half of his paycheck into his checking
account and buy a bond with the other half of his income.
At midmonth, Jim would sell the bond and deposit the $600 into
his checking account to pay the second half of the month’s bills.
Following this strategy, Jim’s average money holdings would be
$300.
PART III The Core of Macroeconomic Theory
The Transaction Motive
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The Demand for Money
PART III The Core of Macroeconomic Theory
The Transaction Motive
 FIGURE 11.4 The Demand Curve for Money Balances
The quantity of money demanded (the amount of money households and firms want to hold) is a
function of the interest rate.
Because the interest rate is the opportunity cost of holding money balances, increases in the
interest rate reduce the quantity of money that firms and households want to hold and decreases
in the interest rate increase the quantity of money that firms and households want to hold.
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PART III The Core of Macroeconomic Theory
Assume that there are no management costs associated with
buying and selling bonds. What is the impact of an increase in the
interest rate on money holdings and interest revenue?
a.
Both money holdings and interest revenue would rise.
b.
Both money holdings and interest revenue would decline.
c.
Money holdings would rise and interest revenue would
decline.
d.
Money holdings would decline, and interest revenue would
rise.
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PART III The Core of Macroeconomic Theory
Assume that there are no management costs associated with
buying and selling bonds. What is the impact of an increase in the
interest rate on money holdings and interest revenue?
a.
Both money holdings and interest revenue would rise.
b.
Both money holdings and interest revenue would decline.
c.
Money holdings would rise and interest revenue would
decline.
d. Money holdings would decline, and interest revenue
would rise.
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The Demand for Money
The Speculation Motive
PART III The Core of Macroeconomic Theory
speculation motive One reason for holding bonds
instead of money: Because the market price of interestbearing bonds is inversely related to the interest rate,
investors may want to hold bonds when interest rates are
high with the hope of selling them when interest rates fall.
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The Demand for Money
The Total Demand for Money
The total quantity of money demanded in the economy is the sum of
the demand for checking account balances and cash by both
households and firms.
PART III The Core of Macroeconomic Theory
At any given moment, there is a demand for money—for cash and
checking account balances. Although households and firms need to
hold balances for everyday transactions, their demand has a limit.
For both households and firms, the quantity of money demanded at
any moment depends on the opportunity cost of holding money, a cost
determined by the interest rate.
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PART III The Core of Macroeconomic Theory
Which of the following is a better measure of the opportunity cost
of holding money balances?
a.
The demand for money curve.
b.
The interest rate.
c.
The transactions motive.
d.
The optimal money balance.
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PART III The Core of Macroeconomic Theory
Which of the following is a better measure of the opportunity cost
of holding money balances?
a.
The demand for money curve.
b. The interest rate.
c.
The transactions motive.
d.
The optimal money balance.
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EC ON OMIC S IN PRACTICE
ATMs and the Demand for Money
PART III The Core of Macroeconomic Theory
Italy makes a great case study of the
effects of the spread of ATMs on the
demand for money. In Italy, virtually all
checking accounts pay interest. What
doesn’t pay interest is cash.
The study found that the demand for
cash responds to changes in the
interest rate paid on checking
accounts. The higher the interest rate,
the less cash held.
In other words, when the interest rate
on checking accounts rises, people go
to ATM machines more often and take
out less in cash each time, thereby
keeping, on average, more in checking
accounts earning the higher interest
rate.
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The Demand for Money
PART III The Core of Macroeconomic Theory
The Effect of Nominal Income on the Demand for Money
 FIGURE 11.5 An Increase in Nominal Aggregate Output
(Income) (P •Y) Shifts the Money Demand Curve to the Right
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The Demand for Money
The Effect of Nominal Income on the Demand for Money
The demand for money depends negatively on the interest rate, r, and
positively on real income, Y, and the price level, P.
TABLE 11.1 Determinants of Money Demand
1. The interest rate: r (The quantity of money demanded is a negative
function of the interest rate.)
PART III The Core of Macroeconomic Theory
2. Aggregate nominal output (income) P • Y
a. Real aggregate output (income): Y (An increase in Y shifts the
money demand curve to the right.)
b. The aggregate price level: P (An increase in P shifts the money
demand curve to the right.)
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PART III The Core of Macroeconomic Theory
The demand for money increases when:
a.
Both the dollar volume of transactions and the average
transaction amount increase.
b.
Both the dollar volume of transactions and the average
transaction amount decrease.
c.
The dollar volume of transactions increases and the average
transaction amount decreases.
d.
The dollar volume of transactions decreases and the average
transaction amount increases.
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PART III The Core of Macroeconomic Theory
The demand for money increases when:
a.
Both the dollar volume of transactions and the average
transaction amount increase.
b.
Both the dollar volume of transactions and the average
transaction amount decrease.
c.
The dollar volume of transactions increases and the average
transaction amount decreases.
d.
The dollar volume of transactions decreases and the average
transaction amount increases.
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The Equilibrium Interest Rate
We are now in a position to consider one of the key questions in
macroeconomics: How is the interest rate determined in the economy?
PART III The Core of Macroeconomic Theory
The point at which the quantity of money demanded equals the quantity of
money supplied determines the equilibrium interest rate in the economy.
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The Equilibrium Interest Rate
Supply and Demand in the Money Market
PART III The Core of Macroeconomic Theory
 FIGURE 11.6 Adjustments in the Money
Market
Equilibrium exists in the money market
when the supply of money is equal to
the demand for money and thus when
the supply of bonds is equal to the
demand for bonds.
At r0 the price of bonds would be bid up
(and thus the interest rate down).
At r1 the price of bonds would be bid
down (and thus the interest rate up).
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PART III The Core of Macroeconomic Theory
When the interest rate is above the equilibrium interest rate:
a.
People will move out of bonds and into money—hold larger
cash balances.
b.
The quantity of money demanded is too high to achieve
equilibrium.
c.
The quantity of money demanded is greater than the quantity
of money supplied.
d.
There is more money in circulation than households and
firms want to hold.
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PART III The Core of Macroeconomic Theory
When the interest rate is above the equilibrium interest rate:
a.
People will move out of bonds and into money—hold larger
cash balances.
b.
The quantity of money demanded is too high to achieve
equilibrium.
c.
The quantity of money demanded is greater than the quantity
of money supplied.
d. There is more money in circulation than households and
firms want to hold.
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The Equilibrium Interest Rate
Changing the Money Supply to Affect the Interest Rate
 FIGURE 11.7 The Effect of an Increase in
the Supply of Money on the Interest Rate
PART III The Core of Macroeconomic Theory
An increase in the supply of money
from MS0 to MS1 lowers the rate of
interest from 7 percent to 4 percent.
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PART III The Core of Macroeconomic Theory
An increase in the money supply, without a change in the demand
for money will:
a.
Increase the equilibrium interest rate.
b.
Decrease the equilibrium interest rate.
c.
Result in an excess demand for money.
d.
Decrease the quantity of money demanded.
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PART III The Core of Macroeconomic Theory
An increase in the money supply, without a change in the demand
for money will:
a.
Increase the equilibrium interest rate.
b. Decrease the equilibrium interest rate.
c.
Result in an excess demand for money.
d.
Decrease the quantity of money demanded.
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The Equilibrium Interest Rate
Increases in P • Y and Shifts in the Money Demand Curve
 FIGURE 11.8 The Effect of an Increase in
Nominal Income (P • Y) on the Interest Rate
PART III The Core of Macroeconomic Theory
An increase in nominal income (P • Y)
shifts the money demand curve from Md0
to Md1, which raises the equilibrium
interest rate from 4 percent to 7 percent.
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The Equilibrium Interest Rate
Zero Interest Rate Bound
By the middle of 2008 the Fed had driven the short-term interest rate
close to zero, and it remained at essentially zero through the middle of
2010.
PART III The Core of Macroeconomic Theory
The Fed does this, of course, by increasing the money supply until the
intersection of the money supply at the demand for money curve is at
an interest rate of roughly zero.
The Fed cannot drive the interest rate lower than zero, preventing it
from stimulating the economy further.
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Looking Ahead: The Federal Reserve and Monetary Policy
tight monetary policy Fed policies that contract the money supply
and thus raise interest rates in an effort to restrain the economy.
PART III The Core of Macroeconomic Theory
easy monetary policy Fed policies that expand the money supply
and thus lower interest rates in an effort to stimulate the economy.
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PART III The Core of Macroeconomic Theory
If the Fed wants to maintain the interest rate constant, it will have
to:
a.
Increase the money supply when the demand for money
increases.
b.
Increase the money supply when the demand for money
decreases.
c.
Leave the money supply unchanged regardless of changes
in the demand for money.
d.
Decrease the reserve requirement when the demand for
money shifts to the left.
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PART III The Core of Macroeconomic Theory
If the Fed wants to maintain the interest rate constant, it will have
to:
a.
Increase the money supply when the demand for money
increases.
b.
Increase the money supply when the demand for money
decreases.
c.
Leave the money supply unchanged regardless of changes
in the demand for money.
d.
Decrease the reserve requirement when the demand for
money shifts to the left.
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REVIEW TERMS AND CONCEPTS
easy monetary policy
interest
PART III The Core of Macroeconomic Theory
nonsynchronization of income and spending
speculation motive
tight monetary policy
transaction motive
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CHAPTER 11 APPENDIX A
The Various Interest Rates in the U.S. Economy
The Term Structure of Interest Rates
The term structure of interest rates is the relationship among the interest
rates offered on securities of different maturities.
PART III The Core of Macroeconomic Theory
According to a theory called the expectations theory of the term structure
of interest rates, the 2-year rate is equal to the average of the current 1year rate and the 1-year rate expected a year from now.
Fed behavior may directly affect people’s expectations of the future shortterm rates, which will then affect long-term rates.
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CHAPTER 11 APPENDIX A
The Various Interest Rates in the U.S. Economy
Types of Interest Rates
Three-Month Treasury Bill Rate Probably the most widely followed short-term
interest rate.
Government Bond Rate There are 1-year bonds, 2-year bonds, and so on, up to 30year bonds. Bonds of different terms have different interest rates.
PART III The Core of Macroeconomic Theory
Federal Funds Rate The rate banks are charged to borrow reserves from other banks.
Generally a 1-day rate on which the Fed has the most effect through its open market
operations.
Commercial Paper Rate Short-term corporate IOUs that offer a designated rate of
interest depending on the financial condition of the firm and the maturity date of the
IOU.
Prime Rate A benchmark that banks often use in quoting interest rates to their
customers depending on the cost of funds to the bank; it moves up and down with
changes in the economy.
AAA Corporate Bond Rate Classified by various bond dealers according to their risk.
Bonds have a longer maturity than commercial paper. The interest rate on bonds
rated AAA is the triple A corporate bond rate, the rate that the least risky firms pay on
the bonds that they issue.
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CHAPTER 11 APPENDIX B
The Demand For Money: A Numerical Example
TABLE 11B.1 Optimum Money Holdings
PART III The Core of Macroeconomic Theory
1
Number of
Switchesa
2
Average Money
Holdingsb
0
$600.00
1
3
Average Bond
Holdingsc
r  5 percent
$
4
Interest
Earnedd
5
Cost of
Switchinge
6
Net
Profitf
0.00
$ 0.00
$0.00
$0.00
300.00
300.00
15.00
2.00
13.00
2
200.00
400.00
20.00
4.00
16.00
3
150.00*
450.00
22.50
6.00
16.50
4
120.00
480.00
24.00
8.00
16.00
Assumptions: Interest rate r  0.05. Cost of switching from bonds to money equals $2 per transaction.
r  3 percent
0
$600.00
1
$
0.00
$ 0.00
$0.00
$0.00
300.00
300.00
9.00
2.00
7.00
2
200.00*
400.00
12.00
4.00
8.00
3
150.00
450.00
13.50
6.00
7.50
4
120.00
480.00
14.40
8.00
6.40
Assumptions: Interest rate r  0.03. Cost of switching from bonds to money equals $2 per transaction.
*Optimum money holdings.aThat is, the number of times you sell a bond.bCalculated as 600/(col. 1  1).cCalculated as 600  col. 2.
dCalculated as r  col. 3, where r is the interest rate.eCalculated as t  col. 1, where t is the cost per switch ($2).fCalculated as col. 4  col. 5.
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