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Chapter 19
The Demand for Real Money
Balances and Market
Equilibrium
©2000 South-Western College Publishing
Real Money Balances
•The quantity of money
expressed in real terms
•The nominal money supply,
M, divided by overall price
level, P, or M/P
2
Transaction Motive
A motive for holding money
based on the need to make
payments
3
Precautionary Motive
A motive for holding money
based on a precaution against
unforeseen developments
4
Average holdings of real money balances over the month
Real Money Holdings by a Typical Household
$2,100
$1,100
Exhibit 19 - 1
Transactions
Demand
Transactions
Demand
$100
Precautionary Demand
Time
5
Benefits of Holding Real
Money Balances
The stream of services that
real balances yield defined as
time and distress saved by
having money on hand for
immediate use
6
How Households and Firms Decide What
Amount of Real Balances to Hold
The benefits of holding real money
balances are:
• To fulfill a stream of services related to
having money available when needed,
including not having to pay a brokerage
fee to get money and not having to wait to
get money
• To be able to make payments when due
Exhibit 19 - 2
7
Costs of Holding Real Money
Balances
The additional foregone
interest that holding
nonmonetary financial assets
would have yielded
8
How Households and Firms Decide What
Amount of Real Balances to Hold
The costs of holding real money balances
are:
• The foregone interest that the
nonmonetary balances of households and
firms would have earned
Decision Rule:
• Hold real money balances as long as the
benefits are greater than the costs
Exhibit 19 - 2 cont.
9
A Demand Curve for Real Money Balances
Interest
Rate
(percent)
Demand
Real Money Balances
10
Exhibit 19 - 3
Liquidity Preference
A theory of the demand for
money developed by John
Maynard Keynes that results in
an inverse relationship between
the quantity of money demanded
and the interest rate
11
Speculative Demand for Money
The theory that individuals will
demand to hold:
•money when interest rates are low
(bond prices high) to avoid capital
losses when interest rates rise, and
•bonds when interest rates are high
(bond prices low) to capture capital
gains when interest rates fall
12
Liquidity Trap
When interest rates are very
low (bond prices very high),
the demand for money
becomes perfectly horizontal
and the economy is in a
liquidity trap; the Fed is
unable to lower interest rates
by increasing the supply of
money
13
A Demand Curve for Real Money Balances
Interest
Rate
(percent)
MS
MS
Liquidity
trap
Real Money Balances
14
What is real income?
Nominal income divided by a
price index
15
A Demand Curve for Real Money Balances
Interest
Rate
Decrease in
Demand
Increase in
Demand
D'
D
D''
Real Money Balances
16
Exhibit 19 - 4
Factors That Affect the Demand for
Real Money Balances
An increase in …
Will cause the demand
for money to ...
Income
Increase
Wealth
Increase
Payment Technologies
Decrease
Expected Inflation
Decrease
Risk of other Financial Assets
Increase
Liquidity of Other Financial Assets Decrease
Exhibit 19 - 5
17
Factors That Affect the Demand for
Real Money Balances
A decrease in …
Will cause the demand
for money to ...
Income
Decrease
Wealth
Decrease
Payment Technologies
Increase
Expected Inflation
Increase
Risk of other Financial Assets
Decrease
Liquidity of Other Financial Assets Increase
Exhibit 19 - 5 cont.
18
Market Equilibrium in the Market for
Real Money Balances
Money Supply
Interest
Rate
(percent)
6
A
Demand
Real Money Balances
19
Exhibit 19 -6
Market Equilibrium in the Market for
Real Money Balances
MS
Interest
Rate
(percent)
MS'
Increase
Decrease
Real Money Balances
Exhibit 19 - 7
20
Increases in the Supply of Real Balances
MS
MS'
Interest
Rate
(percent)
A
B Demand
Real Money Balances
21
Exhibit 19 -8
Expansionary Open Market Operations May
Eventually Lead to Increases in Demand
MS
MS'
Interest
Rate
(percent)
A
C
D'
B
D
Real Money Balances
Exhibit 19 - 9
22
Other Changes Can Also Shift the Demand
for Real Balances Curve
MS
Interest
Rate
(percent)
D'
D
Real Money Balances
Exhibit 19 - 10
23
Monetarism
The school of thought that
emphasizes the importance of
changes in the nominal money
supply as a cause of
fluctuations in prices,
employment, and output
24
Equation of Exchange
M  V = GDP = P  Y
25
Velocity
The number of times the
money supply turns over
during a year to mediate all
the purchases of goods and
services comprising GDP
26
Quantity Theory of Money
The theory that velocity is
stable or fixed and that
changes in the money supply
lead to proportional changes
in GDP
27
Average Daily Holding of
Funds
•A household’s demand for real
money balances during the
month
•The amount of each
withdrawal divided by two
28
Average Daily Holdings of Funds
Number of Broker Calls per Month and the
Average Holdings of Real Balances
(Transactions Demand for Real Balances)
$2,000
Income = $2,000 / month
Price level = 1
0 Calls to Broker
$1,000
Exhibit 19 - 11
30 Days
29
Average Daily Holdings of Funds
Number of Broker Calls per Month and the
Average Holdings of Real Balances
(Transactions Demand for Real Balances)
$2,000
Income = $2,000 / month
Price level = 1
1 Calls to Broker
$1,000
$500
Exhibit 19 - 11 cont.
30 Days
30
Average Daily Holdings of Funds
Number of Broker Calls per Month and the Average
Holdings of Real Balances
(Transactions Demand for Real Balances)
$2,000
Income = $2,000 / month
Price level = 1
2 Calls to Broker
$666.67
$333.33
Exhibit 19 -11 cont.
30 Days
31
Benefits and Costs of Additional
Calls to the Broker
(A) = Transactions demand for money if call not made
(B) = Transactions demand for money if call made
Benefit = Interest on Additional bonds held
Call
(A)
0
$1,000
1
1,000
2
500
3
333
4
250
Exhibit 19 - 14
(B)
-----$500
333
250
200
(A) - (B)
-----$500
167
83
50
Benefit
$2.50
.83
.43
.25
32
Benefits and Costs of Calls to
Broker if the Interest Rate
Increases to 1 % Per Month
(A) = Transactions demand for money if call not made
(B) = Transactions demand for money if call made
Benefit = Interest on Additional bonds held
Call
(A)
0
$1,000
1
1,000
2
500
3
333
4
250
Exhibit 19 - 15
(B)
-----$500
333
250
200
(A) - (B)
-----$500
167
83
50
Benefit
$5.00
1.67
.83
.50
33