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Demand for Money The Price of Money • Foregone interest is the opportunity cost (price) of money people choose to hold. The Demand for Money • The demand for money is the quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus. • A portfolio decision is the choice of how (where) to hold idle funds. LO1 The Demand for Money • Although holding money provides little or no interest, there are reasons for doing so: – Transactions demand. – Precautionary demand. – Speculative demand. LO1 The Demand for Money • Transactions demand for money – Money held for the purpose of making everyday market purchases. • Precautionary demand for money – Money held for unexpected market transactions or for emergencies. LO1 The Demand for Money • Speculative demand for money – Money held for speculative purposes, for later financial opportunities. LO1 Why Hold Money • John Maynard Keynes noted that people had three reasons for holding money – People hold money to make transactions – People hold money for precautionary reasons – People hold money to speculate Why Hold money • Economists have since identified four factors that influence the three Keynesian motives for holding money – – – – The price level Income The interest rate Credit availability The Keynesian Motives for Holding Money • The transaction motive – Individuals have day-to-day purchases for which they pay in cash or by check – Individuals take care of their rent or mortgage payment, car payment, monthly bills and major purchases by check – Businesses need substantial checking accounts to pay their bills and meet their payrolls Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-20 The Keynesian Motives for Holding Money • The precautionary motive – People will keep money on hand just in case some unforeseen emergency arises • They do not actually expect to spend this money, but they want to be ready if the need arises Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-21 The Keynesian Motives for Holding Money • The speculative motive – When interest rates are very low you don’t stand to lose much holding your assets in the form of money – Alternatively, by tying up your assets in the form of bonds, you actually stand to lose money should interest rates rise • You would be locked into very low rates – This motive is based on the belief that better opportunities for investment will come along and that, in particular, interest rates will rise Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-22 Four Influences on the Demand for Money • The price level – As the price level rises, people need to hold higher money balances to carry out day-to-day transactions – As the price level rises, the purchasing power of the dollar declines, so the longer you hold money, the less that money is worth – Even though people tend to cut down on their money balances during periods of inflation, as the price level rises people will hold larger money balances Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-23 Four Influences on the Demand for Money • Income – The more you make, the more you spend – The more you spend, the more money you need to hold as cash or in your checking account – Therefore as income rises, so does the demand for money balances Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-24 Four Influences on the Demand for Money • Interest rates – The quantity of money demanded (held) goes down as interest rates rise • The alternative to holding your assets in the form of money is to hold them in some type of interest bearing paper • As interest rates rise, these assets become more attractive than money balances Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-25 Four Influences on the Demand for Money • Credit availability – If you can get credit, you don’t need to hold so much money • The last three decades have seen a veritable explosion in consumer credit in the form of credit cards and bank loans • Over this period, increasing credit availability has been exerting a downward pressure on the demand for money Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-26 Four Influences on the Demand for Money • Four generalizations – As interest rates rise, people tend to hold less money – As the rate of inflation rises, people tend to hold more money – As the level of income rises, people tend to hold more money – As credit availability increases, people tend to hold less money Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-27 The Demand Schedule for Money The Three Demands for Money A.Transactions demand 20 B. Precautionary demand 20 C. Speculative demand 20 18 16 Precautionary demand 14 Transactions demand Speculative demand 12 10 10 10 8 6 4 2 100 200 300 400 100 200 100 200 300 Quantity of money (in $ billions) 400 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 500 600 700 800 900 1,000 13-28 Total Demand for Money 20 18 16 14 12 10 Total demand for money 8 6 4 2 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 Quantity of money (in $ billions) This is the sum of the transaction demand, precautionary demand, and speculative demand for money shown in the previous slide Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-29 Total Demand for Money and the Supply of Money The interest rate of 7.2 percent is found at the intersection of the total demand for money and the supply of money (M) 20 18 M 16 14 12 10 7.2% 8 Total demand for money 6 Since at any given time the supply of money (M) is fixed it can be represented as a vertical line 4 2 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 Quantity of money (in $ billions) Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-30 Interest Rate (percent per year) Money Market Equilibrium Money supply 9 E1 7 The amount of money demanded (held) depends on interest rates Money demand 0 g2 g1 Quantity Of Money (billions of dollars) LO1 Liquidity Trap • The liquidity trap is the portion of the money-demand curve that is horizontal. • People are willing to hold unlimited amounts of money at some (low) interest rate. LO2 Constraints on Monetary Stimulus A liquidity trap can stop interest rates from falling Interest Rate Demand for money E1 E2 The liquidity trap g1 g2 Quantity Of Money LO2