Download Principles of Economics, Case/Fair/Oster, 10e

Money Demand and
the Equilibrium
Interest Rate
Lecture 7
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
The Equilibrium Interest Rate
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
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.
When interest rates rise, the prices of existing bonds fall.
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.
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.
The Demand for Money
The Transaction Motive
 FIGURE 26.1 The Nonsynchronization of Income and Spending
Income arrives only once a month, but spending takes place continuously.
The Demand for Money
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.
The Demand for Money
 FIGURE 26.3 Jim’s Monthly Checking Account Balances: Strategy 2
The Transaction Motive
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.
The Demand for Money
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.
The Demand for Money
The Speculation Motive
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.
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.
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.
EC ON OMIC S IN PRACTICE
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.
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.
The Demand for Money
The Effect of Nominal Income on the Demand for Money
 FIGURE 26.5 An Increase in Nominal Aggregate Output
(Income) (P •Y) Shifts the Money Demand Curve to the Right
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 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. 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.)
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.
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).
At r1 the price of bonds would be bid
down (and thus the interest rate up).
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 MS0 to MS1 lowers the rate of
interest from 7 percent to 4 percent.
The Equilibrium Interest Rate
Increases in P • Y and Shifts in the Money Demand Curve
 FIGURE 26.8 The Effect of an Increase in
Nominal Income (P • Y) on the Interest Rate
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.
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.
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.
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.
REVIEW TERMS AND CONCEPTS
easy monetary policy
interest
nonsynchronization of income and spending
speculation motive
tight monetary policy
transaction motive