Motives for Holding Money

TM 14-1Copyright © 1998 Addison Wesley Longman, Inc.

Motives for Holding Money

• Transaction



• Transaction

• Precautionary



• Transaction

• Precautionary

• Portfolio


Portfolio Motive

The precautionary and transaction motives justify the classical economists’ argument that income determines the demand for money. The Portfolio motive distinguishes the classical and Keynesian theory of demand for money.


Portfolio Motive

According to the Keynes, there is a speculative motive for holding money.


Portfolio Motive

According to the Keynes, there is a speculative motive for

holding money. People hold money to take advantage of variation in bond prices in response to the expected changes in interest rates.


Bond Prices and Interest Rates

Perpetuity: Non-maturing bond that pays an infinite stream of coupon returns.



What is the current market price of a bond that matures two years from now?



What is the current market price of a bond that matures two years from now?

PV = C/ (1+r) + C/ (1+r)2 + FV/ (1+r) 2



What is the current market price of a bond that matures n years from now?

PV = C/ (1+r) +… + C/ (1+r)n + FV/ (1+r)n



What is the current market price of a perpetuity ?

1) PB = C/ (1+r) + C/ (1+r)2 + C/ (1+r)3

+ C/ (1+r)4 + C/ (1+r)5….




We can reduce equation # 1 to a simple formula that shows the inverse relationship between bond prices and interest rates.




We can reduce this to a simple formula that shows the inverse relationship

between bond prices and interest rates. In order to do so we should multiply both sides by (1+r).




We can reduce this to a simple formula that shows the inverse relationship between bond prices and interest rates. In order to do so we should multiply both sides by (1+r).

2) (1+r) PB = C + C/ (1+r)1 + C/ (1+r)2 + C/ (1+r)3 + C/ (1+r)4….]





If we subtract 1 from 2, we have:

(1+r) PB - PB = C + C/ (1+r)1 + C/ (1+r)2 + C/ (1+r)3 + C/ (1+r)4….] - [C/ (1+r)1 + C/ (1+r)2

+ C/ (1+r)3 + C/ (1+r)4 ……..]


Bond Prices and Interest RatesWhat is the current market price of a perpetuity ?



(1+r) PB - PB = C + C/ (1+r)1 + C/ (1+r)2 + C/ (1+r)3 + C/ (1+r)4….] - [C/ (1+r)1 + C/ (1+r)2 + C/ (1+r)3 + C/ (1+r)4 ……..]

eliminating those with +s and -s , we have :


Bond Prices and Interest RatesWhat is the current market price of a perpetuity ?



(1+r) PB - PB = C + C/ (1+r)1 + C/ (1+r)2 + C/ (1+r)3 + C/ (1+r)4….] - [C/ (1+r)1 + C/ (1+r)2 + C/ (1+r)3 + C/ (1+r)4 ……..]

eliminating those with +s and -s , we have

(1+r) PB - PB = C or (1+r -1 ) PB = C

PB = C / r



PB = C / r

This says that bond price , PB ,varies inversely with interest rate, r. The higher the interest rates the lower bond prices. Or, the higher the bond prices the lower the interest rates.



Question: If you expect interest rates to rise (fall) tomorrow, what will you advise your client?


what determines the demand for money?

• The Influences on Money Holding

• The quantity of money people hold depends on:

1) The price level

2) The interest rate

3) Real GDP

4) Financial innovation



• The Price Level

• Nominal money is the quantity of money measured in dollars.



• The Price Level

• Nominal money is the quantity of money measured in dollars.

• The quantity of nominal money demanded is proportional to the price level.



• The Price Level• Nominal money is the quantity of money measured in dollars.


• Real money is the quantity of money measured in constant dollars.



• The Price Level• Nominal money is the quantity of money measured in dollars.


• Real money is the quantity of money measured in constant dollars.

• The quantity of real money demanded is independent of the price level.



The Interest Rate. The opportunity cost of holding money is the interest rate a person could earn on assets they could hold instead of money.



• Real GDP

• Money holdings depend upon planned spending.



• Real GDP• Money holdings depend upon planned spending.

• The quantity of money demanded in the economy as a whole depends on Real GDP.



• Financial Innovation

• Changing technologies affect the quantity of money held.



• Financial Innovation

• Changing technologies affect the quantity of money held. These include:

• Daily interest checking deposits



• Financial Innovation• Changing technologies affect the quantity of money held. These include:


• Automatic transfers between checking and savings deposits






• Automatic teller machines






• Automatic teller machines

• Credit cards


The Demand for Money

• The Demand for Money Curve

• The demand for money is the relationship between the quantity of real money demanded and the interest rate.



Real money (trillions of 1992 dollars)

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Effect of anincrease in the interestrate

Effect of anincrease in the interestrate



• Shifts in the Demand Curve for Real Money

• Changes in real GDP or financial innovation changes the demand for money and shifts the demand curve for real money.


Changes in theDemand for Money


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Effect of decrease inreal GDP or financialinnovation




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Effect of increasein real GDP

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Effect of decrease inreal GDP or financialinnovation


The Demand for Moneyin the United states

Documents

Motives for Holding Money