Download Principles of Economics, Case and Fair,9e

CHAPTER 26 Money Demand and the Equilibrium Interest Rate
PowerPoint Lectures for
Principles of Economics,
9e
; ;
By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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PART V THE CORE OF MACROECONOMIC THEORY
26
Money Demand and
the Equilibrium
Interest Rate
Prepared by:
Fernando & Yvonn Quijano
© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
PART V THE CORE OF MACROECONOMIC THEORY
Money Demand and
the Equilibrium
Interest Rate
26
CHAPTER OUTLINE
Interest Rates and Bond Prices
The Demand for Money
The Transaction Motive
The Speculation Motive
The Total Demand for Money
The Effects of Income and the Price
Level on the Demand for Money
The Equilibrium Interest Rate
Supply and Demand in the Money Market
Changing the Money Supply to Affect the
Interest Rate
Increases in Y and Shifts in the Money
Demand Curve
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Money Market
A. The previous chapter covered the money supply and how
money is created.
B. This chapter covers the demand for money.
C. We need money supply and demand so we can find out
the equilibrium interest rate.
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Demand for Money
Money is simply a part of your wealth. You can
hold assets such as stocks or bonds, or you
can hold wealth in the form of money.
Holding wealth in currency or checking deposits
means that you sacrifice the potential income
from interest and dividends earned on stocks
and bonds.
So why hold money? Because it makes it easier
to conduct transactions. Economists call this
reason for holding money the transactions
demand for money.
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Demand for Money
The opportunity cost of
holding money is the return
that you could have earned
by holding your wealth in
other assets.
PRINCIPLE of Opportunity Cost
The opportunity cost of something
is what you sacrifice to get it.
•
As interest rates increase,
the opportunity cost of
holding money increases,
and the public will demand
less money.
The market rate of interest is a
measure of the opportunity
cost of holding money.
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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.
The Transaction Motive
According to Keynes there were three motives
for holding money: transactions, precautionary,
and speculation. Of these the transactions
motive is most important today.
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
Assumptions
There are only two kinds of assets: bonds and money.
Money earns zero interest, bonds earn positive nominal
interest.
Income and spending are not synchronized. Spending is
exactly equal to income but occurs at times different
from receiving the income.
Nonsynchronization of income and spending describes
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
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Transaction Motive
 FIGURE 26.1 The Nonsynchronization of Income and Spending
Income arrives only once a month, but spending takes place continuously.
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
Money Management and the Optimal Balance
*There is a trade-off between the quantity of money
people want to hold and the interest lost by holding
money.
*The optimal balance is the level of average money
balance that earns the consumer the most net profit, taking
into account both the interest earned on bonds and the
costs paid for switching from bonds to money.
*When interest rates are high people tend to hold very
little money.
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The Demand for Money
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Transaction Motive
 FIGURE 26.2 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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The Demand for Money
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Transaction Motive
 FIGURE 26.3 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.
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The Demand for Money
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Transaction Motive
 FIGURE 26.4 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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The Demand for Money
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Speculation Motive
speculation motive One reason for holding
bonds instead of money: Because the market
price of interest-bearing 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.
The precautionary demand for money has
been largely replaced by credit cards.
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Total Demand for Money
1.The quantity of money demanded at any moment
depends on the opportunity cost of holding money, the
interest rate.
2.Total demand for money includes both household
demand and business demand.
3.At any given moment there is a demand for cash and
checkable deposit balances. Total money demand will
always be less than income. The demand for money at
any moment depends on the opportunity cost of
holding money (the interest rate) and total income.
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The Demand for Money
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Total Demand for Money
ATMs and the Demand
for Money
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.
In other words, in Italy there is an
interest cost to carrying cash instead
of depositing the cash in a checking
account.
Orazio Attansio, Luigi Guiso, and Tullio Jappelli, “The Demand for Money, Financial
Innovation and the Welfare Costs of Inflation: An Analysis with Household Data,” Journal
of Political Economy, April 2002.
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The Demand for Money
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Effects of Income and the Price Level on the Demand for Money
 FIGURE 26.5 An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve
to the Right
An increase in Y means that there is more economic activity. Firms are producing and selling
more, and households are earning more income and buying more. There are more
transactions, for which money is needed. As a result, both firms and households are likely to
increase
holdings
of money
balances
a given
interest rate.
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Pearsontheir
Education,
Inc. Publishing
as Prentice
Hall at
Principles
of Economics
9e by Case, Fair and Oster
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The Demand for Money
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Effects of Income and the Price Level on the Demand for Money
The amount of money needed by firms and
households to facilitate their day-to-day
transactions also depends on the average dollar
amount of each transaction. In turn, the average
amount of each transaction depends on prices, or
instead, on the price level.
TABLE 26.1 Determinants of Money Demand
1. The interest rate: r (The quantity of money demanded is a negative function of the
interest rate.)
2. The dollar volume of transactions
a. Aggregate output (income): Y (An increase in Y shifts the money demand curve to
the right.)
b. The price level: P (An increase in P shifts the money demand curve to the right.)
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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 26 Money Demand and the Equilibrium Interest Rate
Supply and Demand in the Money Market
1.The Fed controls the money supply through its
manipulation of the quantity of bank reserves. We
assume it has a fixed target for the money supply.
2.Money demand is inversely related to the interest
rate. If the money demand is greater than the
money supply, the interest rate rises. If money
demand is less than the money supply, the interest
rate falls.
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The Equilibrium Interest Rate
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
Supply and Demand in the Money Market
 FIGURE 26.6 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),
and at r1 the price of
bonds would be bid down
(and thus the interest rate
up).
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The Equilibrium Interest Rate
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
Changing the Money Supply to Affect the Interest Rate
 FIGURE 26.7 The Effect of
an Increase in the Supply of
Money on the Interest Rate
An increase in the supply of money
from
to
lowers the rate of
interest from 7 percent to 4
percent.
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The Equilibrium Interest Rate
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
Increases in Y and Shifts in the Money Demand Curve
 FIGURE 26.8 The Effect of
an Increase in Income on the
Interest Rate
An increase in aggregate output
(income) shifts the money demand
curve from
to , which raises
the equilibrium interest rate from 4
percent to 7 percent.
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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.
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
Real and Nominal Interest Rates
Table 12.1 Expected Real Rates of Interest for Five Countries
3-Month
Nominal
Interest Rate
Inflation Rate
Forecast for
2004
Australia
5.5%
2.3%
2.2%
Canada
2.6
1.7
0.9
Denmark
2.3
1.6
0.7
Switzerland
0.3
0.6
-0.3
United States
1.1
1.5
-0.4
Country
Expected
Real Rate of
Interest
Both nominal and expected real interest rates
differ among developed countries.
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
Let’s summarize what we have learned so far in this chapter:
 The interest rate is determined by the equality of the supply
of money and the demand for money.
 By changing the supply of money, the central bank can
affect the interest rate.
 The central bank changes the supply of money through open
market operations, which are purchases or sales of bonds
for money.
 Open market operations in which the central bank increases
the money supply by buying bonds lead to an increase in the
price of bonds and a decrease in the interest rate.
 Open market operations in which the central bank decreases
the money supply by selling bonds lead to a decrease in the
price of bonds and an increase in the interest rate.
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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
REVIEW TERMS AND CONCEPTS
easy monetary policy
interest
nonsynchronization of income
and spending
speculation motive
tight monetary policy
transaction motive
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APPENDIX A
THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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.
According to a theory called the expectations
theory of the term structure of interest rates, the 2year rate is equal to the average of the current 1year rate and the 1-year rate expected a year from
now.
People’s expectations of higher future short-term
interest rates are likely to increase. These
expectations will then be reflected in current longterm interest rates.
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APPENDIX A
THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
TYPES OF INTEREST RATES
Three-Month Treasury Bill Rate
Government Bond Rate
Federal Funds Rate
Commercial Paper Rate
Prime Rate
AAA Corporate Bond Rate
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APPENDIX B
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
THE DEMAND FOR MONEY: A NUMERICAL EXAMPLE
TABLE 26B.1 Optimum Money Holdings
1
2
3
Number of Average Money
Average Bond
a
b
Switches
Holdings
Holdingsc
r = 5 percent
0
$600.00
1
$
4
Interest
Earnedd
5
Cost of
Switchinge
6
Net
Profitf
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. 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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