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PART III THE CORE OF MACROECONOMIC THEORY
11
Money Demand and
the Equilibrium
Interest Rate
CHAPTER OUTLINE
The Demand for Money
The Equilibrium Interest Rate
Adapted from:
Fernando & Yvonn Quijano
© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster
11.1 The Demand for Money
CHAPTER 11 Money Demand and the Equilibrium Interest Rate
For simplicity, let us assume that there are only 2 kinds of assets
available to households:
(1) Money: Currency in circulation and deposits in checking
accounts that do not pay interest.
Versus
(2) Bonds: Assume to cover interest-bearing securities of all
kinds.
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, versus how much you want to hold in bonds.
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11.1 The Demand for Money
CHAPTER 11 Money Demand and the Equilibrium Interest Rate
(1) The Transaction Motive
You decision to hold money involves a trade-off between:
(1) High liquidity of money to meet your transaction needs (transaction
motive);
(2) Interest income offered by bonds.
The opportunity cost of holding money is the interest rate foregone on
bonds. For instance, if you can earn 8% a year on bond, then holding
an additional $100 in money costs you $8 a year.
Illustration:
Suppose that Jim earns $1200 per month. How could he manage his
income optimally?
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CHAPTER 11 Money Demand and the Equilibrium Interest Rate
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 [(starting balance + ending balance) / 2].
But he is giving up interest income from investing in bonds!
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CHAPTER 11 Money Demand and the Equilibrium Interest Rate
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.
Jim can continue to lower his average money holdings, but the switching from bonds to money incurs
costs such as brokerage fees.
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TABLE 11B.1 Optimum Money Holdings
1
2
3
Number of Average Money
Average Bond
a
b
Switches
Holdings
Holdingsc
4
Interest
Earnedd
5
Cost of
Switchinge
6
Net
Profitf
CHAPTER 11 Money Demand and the Equilibrium Interest Rate
r = 5 percent
0
$600.00
1
$
0.00
$ 0.00
$0.00
300.00
300.00
15.00
2.00
$
0.00
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
300.00
300.00
9.00
2.00
$
0.00
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. a That is, the number of times you sell a bond. b Calculated as 600/(col. 1 + 1).
c Calculated as 600 − col. 2.
d Calculated as r × col. 3, where r is the interest rate. e Calculated as t × col. 1, where t is the cost per switch ($2).
f Calculated as col. 4 − col. 5
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CHAPTER 11 Money Demand and the Equilibrium Interest Rate
Number of switches:
0 = Jim puts all the $1200 into his checking account.
1 = Jim buys one bond, indicating he puts $600 into his checking account,
and uses the remaining $600 to buy bond.
2 = Jim buys two bonds, indicating that he puts $400 into his checking
account, and buys two $400 bonds.
3 = Jim buys three bonds, indicating that he puts $300 into his checking
account, and buys 3 $300 bonds.
4 = Jim buys four bonds, indicating that he puts $240 into his checking
account, and buys 4 $240 bonds.
Average Money Holdings (AMH):
AMH = (starting balance + ending balance) / 2
When switches
When switches
When switches
When switches
When switches
= 0, AMH = (1200 + 0) / 2 = $600
= 1, AMH = (600 + 0) / 2 = $300
= 2, AMH = (400 + 0) / 2 = $200
= 3, AMH = (300 + 0) / 2 = $150
= 4, AMH = (240 + 0) / 2 = $120
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Average Bond Holdings (ABH):
CHAPTER 11 Money Demand and the Equilibrium Interest Rate
ABH = (starting balance + ending balance) / 2
When switches
When switches
When switches
When switches
When switches
= 0, ABH = (0 + 0) / 2 = $0
= 1, ABH = (600 + 0) / 2 = $300
= 2, ABH = (800 + 0) / 2 = $400
= 3, ABH = (900 + 0) / 2 = $450
= 4, ABH = (960 + 0) / 2 = $480
Summary:
When r = 5%, optimal money holdings = $150
When r = 3%, optimal money holdings = $200
The lower the rate, the more money on average is held.
The higher the rate, the higher the opportunity cost (more interest foregone)
from holding money, the less money on average is held.
 The demand for money depends negatively on interest rate (i.e. the
money demand curve is downward-sloping).
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(2) The Speculation Motive
CHAPTER 11 Money Demand and the Equilibrium Interest Rate
To explain the speculative motive, we need to understand the relation between
bond prices and interest rates
Illustration:
On Jan 2, 2008, Company XYZ issued a 15-year bond that had a face value of
$1000, and paid a couple of $100 per year.
Suppose that the market-determined price was $900.
Interest rate = (100/900)*100 = 11.1% p.a.
Suppose that the holder of the XYZ bond (Jim) wanted to sell after a year, what
price could he get?
It all depends on the prevailing interest rate. Let say the interest rate on Jan 2,
2009 was 20%, do you think he will be able to sell for more or less than $900?
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On Jan 2, 2009, another company ABC issued a 15-year bond that had a face
value of $1000. The market-determined price was $900. At the prevailing
interest rate of 20%, the couple payment was $180 p.a.
CHAPTER 11 Money Demand and the Equilibrium Interest Rate
As a rational investor, would you buy from:
(a) Jim at $900, with a coupon payment of $100 per year
(b) company ABC at $900, with a coupon payment of $180 per year
Of course, a rational person would buy from company ABC!
So, in order to dispose of his bond holding, Jim has to lower his selling price
(say to $500).
 When interest rate  from 11.1% to 20%, the prices of existing bonds fall
(from $900 to $500).
This implies a inverse relation between bond prices and interest rates.
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(2) The Speculation Motive
CHAPTER 11 Money Demand and the Equilibrium Interest Rate
When interest rates are high
When interest rates are higher than normal, investors expect them to fall in the
future (and prices of existing bonds will rise).
There is a speculative motive for holding more bonds now (and hence less
money), with the hope of selling them in future when bond prices rise (i.e.
when interest rates fall).
When interest rates are low
When interest rates are lower than normal, investors expect them to rise in the
future (and prices of existing bonds will fall).
There is a speculative motive for holding more money now (and hence less
bonds), with the hope of buying bonds in future when the prices fall (i.e. when
interest rates rise).
 The demand for money depends negatively on interest rate (i.e. the money
demand curve is downward-sloping).
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CHAPTER 11 Money Demand and the Equilibrium Interest Rate
Money Demand Curve
The quantity of money demanded is a
negative function of the interest rate.
A change in r brings a change in money
demanded and a movement along the Md
curve.
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11.2 Other Determinants of Money Demand
CHAPTER 11 Money Demand and the Equilibrium Interest Rate
The demand of money depends on the total dollar volume of transactions in the
economy.
Two components of total dollar volume of transactions are:
a) How many transactions?
b) How much is the average transaction amount?
How many transactions?
A reasonable indicator for the number of transactions is aggregate output
(income), Y.
When Y , there are more transactions in the economy, and Md shifts to the
right.
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CHAPTER 11 Money Demand and the Equilibrium Interest Rate
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How much is the average transaction amount?
CHAPTER 11 Money Demand and the Equilibrium Interest Rate
The average dollar amount of each transaction depends on the prices, P.
If P  twice, the dollar amount of each transaction also double (twice as much
money is needed to conduct the same real transaction), and Md shifts to the
right.
Md = P x L(Y, r)
Money demand is proportional to the price level. If P doubles, Md will also
double
For any given P, money demand depends (through the function L) on Y and r.
When Y , Md 
When r , Md 
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CHAPTER 11 Money Demand and the Equilibrium Interest Rate
11.3 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?
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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CHAPTER 11 Money Demand and the Equilibrium Interest Rate
Supply and Demand in the Money Market
Equilibrium exists in the money
market when the supply of money is
equal to the demand for money (or
equivalently, the supply of bonds is
equal to the demand for bonds).
At r0, Ms > Md
There is an excess demand for
bonds.
 Investors would bid up the
price of bonds, bringing interest
rate down to r*.
At r1, Ms < Md
There is an excess supply of
bonds.
 Investors would bid down the
price of bonds, bringing interest
rate up to r*.
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CHAPTER 11 Money Demand and the Equilibrium Interest Rate
Changing the Money Supply to Affect the Interest Rate
The Fed can expand money
supply by:
1) reduce the required
reserve ratio
2) lower the discount rate
3) buy government
securities in the open
market
An increase in the supply of
money lowers the rate of
interest from 14 percent to 7
percent.
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CHAPTER 11 Money Demand and the Equilibrium Interest Rate
Increases in Y or P and Shifts in the Money Demand Curve
An increase in aggregate
income (Y) or price level (P)
shifts the money demand curve
to the right.
As a result, the equilibrium
interest rate rises from 7
percent to 14 percent.
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