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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
Interest Rates and Bond Prices
Interest The fee that borrowers pay to lenders for
the use of their funds.
Professor Serebryakov
Makes an Economic
Error
Uncle Vanya
by Anton Chekhov
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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
transaction motive The main reason that people
hold money—to buy things.
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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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The Demand for Money
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
The Transaction Motive
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
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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
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.
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The Demand for Money
CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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.
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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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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 their holdings of money balances at a
given interest rate.
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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 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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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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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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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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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
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
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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CHAPTER 26 Money Demand and the Equilibrium Interest Rate
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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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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