11 © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Money Demand, the Equilibrium Interest Rate, and Monetary Policy

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© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

Money Demand,the Equilibrium Interest

Rate, and Monetary Policy

Prepared by: Fernando QuijanoPrepared by: Fernando Quijano and Yvonn Quijano and Yvonn Quijano

Appendix A and Appendix B

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2 of 29© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

Monetary Policy and Interest

• The previous chapter covered the money supply and how money is created. This chapter covers the demand for money.

• Monetary policy is the behavior of the Federal Reserve concerning the money supply.

• Interest is the fee that borrowers pay to lenders for the use of their funds.

• Interest rate is the annual interest payment on a loan expressed as a percentage of the loan.

100loan theofamount

per year receivedinterest rateInterest x

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The Demand for Money

• The main concern in the study of the demand for money is:

• A household or business wants only to hold a fraction of its financial wealth as money. or

• 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.

• 1. Money earns no interest (or very little interest).

• 2. Other financial assets do earn interest.

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The Transaction Motive

• There is a trade-off between the liquidity of money and the interest income offered by other kinds of assets.

• According to Keynes there were three motives for holding money: transactions, precautionary, and speculative. Of these the transactions motive is most important today

• The transaction motive is the main reason that people hold money—to buy things.

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The Transaction Motive

Simplifying assumptions in the study of the demand for money:

• There are only two kinds of assets available to households: bonds and money.

• The typical household’s income arrives once a month, at the beginning of the month.

• Spending occurs at a completely uniform rate—the same amount is spent each day.

• Spending is exactly equal to income for the month.

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The Nonsynchronizationof Income and Spending

• The mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses is called the nonsynchronization of income and spending.

• Income arrives only once a month, but spending takes place continuously.

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Money Management

• 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 money holdings would be $600. For the first half of the month Jim has more than his average of $600 on deposit, and for the second half of the month he has less than his average.

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Money Management

• Is anything wrong with Jim's strategy?

• Yes, Jim’s could decide to deposit half of his paycheck ($1,200) into his checking account, and buy a $600 bond with the other half. At mid-month, he could sell the bond and deposit the $600 into his checking account.

• Month over month, his average money holdings would be $300.

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The Optimal Balance

• 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 Speculation Motive

• The speculation motive: Because the market value of interest-bearing bonds is inversely related to the interest rate, investors may wish to hold bonds when interest rates are high with the hope of selling them when interest rates fall.

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The Speculation Motive

• If someone buys a 10-year bond with a fixed rate of 10%, and a newly issued 10-year bond pays 12%, then the old bond paying 10% will have fallen in value.

• Higher bond prices mean that the interest a buyer is willing to accept is lower than before.

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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.

• Like households, firms must manage their money. They have payrolls to meet and purchases to make; they receive cash and checks from sales; and many firms that deal with the public must make change—they need cash in the cash register. Thus, just like Jim, firms need money to engage in ordinary transactions.

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The Total Demand for Money

• The quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate.

• A higher interest rate raises the opportunity cost of holding money and thus reduces the quantity of money demanded.

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Transactions Volumeand the Price Level

• The total demand for money in the economy depends on the total dollar volume of transactions made.

• The total dollar volume of transactions, in turn, depends on the total number of transactions, and the average transaction amount.

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• When output (income) rises, the total number of transactions rises, and the demand for money curve shifts to the right.

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• When the price level rises, the average dollar amount of each transaction rises; thus, the quantity of money needed to engage in transactions rises, and the demand for money curve shifts to the right.

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The Determinants ofMoney Demand: Review

Determinants of Money Demand

1. The interest rate: r (negative effect)

2. The dollar volume of transactions (positive effect)

a. Aggregate output (income): Y (positive effect)

b. The price level: P (positive effect)

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The Determinants ofMoney Demand: Review

• Money demand answers the question:

• How much money do firms and households desire to hold at a specific point in time, given the current interest rate, volume of economic activity, and price level?

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The Equilibrium Interest Rate

• 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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• At r1, the amount of money in circulation is higher than households and firms wish to hold. They will attempt to reduce their money holdings by buying bonds.

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• At r2, households don’t have enough money to facilitate ordinary transactions. They will shift assets out of bonds and into their checking accounts.

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Changing the MoneySupply to Affect the Interest Rate

• An increase in the supply of money lowers the rate of interest.

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Increases in Y and Shiftsin the Money Demand Curve

• An increase in aggregate output (income) shifts the money demand curve, which raises the equilibrium interest rate.

• An increase in the price level has the same effect.

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Looking Ahead: The FederalReserve and Monetary Policy

• Tight monetary policy refers to Fed policies that contract the money supply in an effort to restrain the economy.

• Easy monetary policy refers to Fed policies that expand the money supply in an effort to stimulate the economy.

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Review Terms and Concepts

easy monetary policy

interest

interest rate

monetary policy

nonsynchronization of income and spending

speculation motive

tight monetary policy

transaction motive

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Appendix A: The VariousInterest Rates in the U.S. Economy

• The Term Structure of Interest Rates:

• According to a theory called the expectations theory of the term structure of interest rates, the 2-year rate is equal to the average of the current 1-year rate and the 1-year rate expected a year from now.

• People’s expectations of future short-term interest rates are reflected in current long-term interest rates.

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Appendix A: The VariousInterest Rates in the U.S. Economy

• 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: The Demand forMoney: A Numerical Example

• The optimal average level of money holdings is the amount that maximizes the profits from money management.

• The cost per switch multiplied by the number of switches must be subtracted from interest revenue to obtain the net profit from money management.

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Appendix B: The Demand forMoney: A Numerical Example

1NUMBER OF SWITCHESa

2AVERAGE MONEY

HOLDINGSb

3AVERAGE BOND

HOLDINGSc

4INTEREST EARNEDd

5COST OF

SWITCHINGe

6NET

PROFITf

r = 5 percent0 $600.00 $ 0.00 $ 0.00 $0.00 $ 0.001 300.00 300.00 15.00 2.00 13.002 200.00 400.00 20.00 4.00 16.003 150.00* 450.00 22.50 6.00 16.504 120.00 480.00 24.00 8.00 16.00

Assumptions: Interest rate r = 0.05. Cost of switching from bonds into money equals $2 per transaction.

r = 3 percent0 $600.00 $ 0.00 $ 0.00 $0.00 $ 0.001 300.00 300.00 9.00 2.00 7.002 200.00* 400.00 12.00 4.00 8.003 150.00 450.00 13.50 6.00 7.504 120.00 480.00 14.40 8.00 6.40

Assumptions: Interest rate r = 0.05. Cost of switching from bonds into 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 x col.3, where r is the interest rate. eCalculated as t x col.1, where t is the cost per switch ($2). fCalculated as col.4 – col.5.

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11 © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Money Demand, the Equilibrium Interest Rate, and Monetary Policy