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Chapter 20: Monetary Policy
The Demand for Money
• Disadvantage of holding money?– Opportunity Cost
• Motives for holding money?– Keynes gave three…
Money Demand
• Transactions demand for money: money people hold to pay everyday expenses.– “walking around money”
• Precautionary demand for money: money people hold to pay unpredictable expenses.– “rainy day money”
• These tend to depend on variables that aren’t in our model.
Money Demand
• Speculative demand for money: money people hold to take advantage of expected changes in non-money financial assets.– Also, think of this as the demand for money as an
asset.
– If the interest rate increases, should I increase or decrease my speculative demand for money?
Money Demand
• If the interest rate increases, should I increase or decrease my speculative demand for money?
• Decrease because the opportunity cost has increased – money is “more expensive.”
• Example: checking account vs. bonds• There is an inverse relationship between the
demand for money and the interest rate.
•Downward-sloping due to speculative demand.
•Equilibrium interest rate.
Bond prices and interest rates
• The interest rate (annual yield) on a bond depends on its market price and its annual interest payment.
• Example: Suppose a 20-year government bond pays $50 annually and is currently selling for $1000. Then,
interest rate = $50/$1000 = 5%
Bond prices and interest rates
• Now, suppose that an decrease in the demand for bonds drops the price of the bond to $500.
interest rate = $50/$500 = 10%
• When the bond price fell, the interest rate rose.
• There is an inverse relationship between bond prices and interest rates.
Interest rates and Investment Demand