1. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 23 PowerPoint Lectures for Principles of Economics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

2. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 2 of 23

3. © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster PART V THE CORE OF MACROECONOMIC THEORY 26 Money Demand and the Equilibrium Interest Rate Fernando & Yvonn Quijano Prepared by:

4. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 4 of 23 26 Interest Rates and Bond PricesThe Demand for MoneyThe Transaction MotiveThe Speculation MotiveThe Total Demand for MoneyThe Effects of Income and the Price Level on the Demand for Money The Equilibrium Interest RateSupply and Demand in the Money MarketChanging the Money Supply to Affect the Interest Rate Increases in Y and Shifts in the Money Demand Curve 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 CHAPTER OUTLINE Money Demand and the Equilibrium Interest Rate PART V THE CORE OF MACROECONOMIC THEORY 26

5. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 5 of 22 The Money Market A.The previous chapter covered the money supply and how money is created. B.This chapter covers the demand for money. C.We need money supply and demand so we can find out the equilibrium interest rate. The money market is the market for money where the amount supplied and the amount demanded meet to determine the nominal interest rate.

6. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 6 of 22 The Demand for Money Money is simply a part of your wealth. You can hold assets such as stocks or bonds, or you can hold wealth in the form of money. Holding wealth in currency or checking deposits means that you sacrifice the potential income from interest and dividends earned on stocks and bonds. So why hold money? Because it makes it easier to conduct transactions. Economists call this reason for holding money the transactions demand for money.

7. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 7 of 22 The Demand for Money PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it. The opportunity cost of holding money is the return that you could have earned by holding your wealth in other assets. The market rate of interest is a measure of the opportunity cost of holding money. As interest rates increase, the opportunity cost of holding money increases, and the public will demand less money.

8. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 8 of 23 The Demand for Money According to Keynes there were three motives for holding money: transactions, precautionary, and speculation. Of these the transactions motive is most important today. The Transaction Motive 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.

9. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 9 of 23 Assumptions There are only two kinds of assets: bonds and money. Money earns zero interest, bonds earn positive nominal interest. Income and spending are not synchronized. Spending is exactly equal to income but occurs at times different from receiving the income. Nonsynchronization of income and spending describes the mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses.

10. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 10 of 23 The Demand for Money The Transaction Motive Income arrives only once a month, but spending takes place continuously.  FIGURE 26.1 The Nonsynchronization of Income and Spending

11. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 11 of 23 Money Management and the Optimal Balance *There is a trade-off between the quantity of money people want to hold and the interest lost by holding money. *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.

12. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 12 of 23 The Demand for Money The Transaction Motive 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.  FIGURE 26.2 Jim’s Monthly Checking Account Balances: Strategy 1

13. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 13 of 23 The Demand for Money 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.  FIGURE 26.3 Jim’s Monthly Checking Account Balances: Strategy 2

14. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 14 of 23 The Demand for Money The Transaction Motive 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.  FIGURE 26.4 The Demand Curve for Money Balances

15. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 15 of 23 The Demand for Money The Speculation Motive speculation motive One reason for holding bonds instead of money: Because the market price of interest-bearing 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 precautionary demand for money has been largely replaced by credit cards.

16. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 16 of 23 The Total Demand for Money 1.The quantity of money demanded at any moment depends on the opportunity cost of holding money, the interest rate. 2.Total demand for money includes both household demand and business demand. 3.At any given moment there is a demand for cash and checkable deposit balances. Total money demand will always be less than income. The demand for money at any moment depends on the opportunity cost of holding money (the interest rate) and total income.

17. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 17 of 23 The Demand for Money The Total Demand for Money ATMs and the Demandfor 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. In other words, in Italy there is an interest cost to carrying cash instead of depositing the cash in a checking account. Orazio Attansio, Luigi Guiso, and Tullio Jappelli, “The Demand for Money, Financial Innovation and the Welfare Costs of Inflation: An Analysis with Household Data,” Journal of Political Economy, April 2002.

18. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 18 of 23 The Demand for Money The Effects of Income and the Price Level on the Demand for Money An increase in Y means that there is more economic activity. Firms are producing and selling more, and households are earning more income and buying more. There are more transactions, for which money is needed. As a result, both firms and households are likely to increase their holdings of money balances at a given interest rate.  FIGURE 26.5 An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right

19. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 19 of 23 The Demand for Money The Effects of Income and the Price Level on the Demand for Money 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.The dollar volume of transactions a. Aggregate output (income): Y (An increase in Y shifts the money demand curve to the right.) b. The price level: P (An increase in P shifts the money demand curve to the right.) The amount of money needed by firms and households to facilitate their day-to-day transactions also depends on the average dollar amount of each transaction. In turn, the average amount of each transaction depends on prices, or instead, on the price level.

20. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 20 of 23 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.

21. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 21 of 23 Supply and Demand in the Money Market 1.The Fed controls the money supply through its manipulation of the quantity of bank reserves. We assume it has a fixed target for the money supply. 2.Money demand is inversely related to the interest rate. If the money demand is greater than the money supply, the interest rate rises. If money demand is less than the money supply, the interest rate falls.

22. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 22 of 23 The Equilibrium Interest Rate Supply and Demand 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 r 0 the price of bonds would be bid up (and thus the interest rate down), and at r 1 the price of bonds would be bid down (and thus the interest rate up).  FIGURE 26.6 Adjustments in the Money Market

23. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 23 of 23 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 to lowers the rate of interest from 7 percent to 4 percent.

24. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 24 of 23 The Equilibrium Interest Rate Increases in Y and Shifts in the Money Demand Curve  FIGURE 26.8 The Effect of an Increase in Income on the Interest Rate An increase in aggregate output (income) shifts the money demand curve from to, which raises the equilibrium interest rate from 4 percent to 7 percent.

25. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 25 of 23 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.

26. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 26 of 21 Real and Nominal Interest Rates Both nominal and expected real interest rates differ among developed countries. Table 12.1 Expected Real Rates of Interest for Five Countries Country 3-Month Nominal Interest Rate Inflation Rate Forecast for 2004 Expected Real Rate of Interest Australia5.5%2.3%2.2% Canada2.61.70.9 Denmark2.31.60.7 Switzerland0.30.6-0.3 United States1.11.5-0.4

27. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 27 of 32 Let’s summarize what we have learned so far in this chapter:  The interest rate is determined by the equality of the supply of money and the demand for money.  By changing the supply of money, the central bank can affect the interest rate.  The central bank changes the supply of money through open market operations, which are purchases or sales of bonds for money.  Open market operations in which the central bank increases the money supply by buying bonds lead to an increase in the price of bonds and a decrease in the interest rate.  Open market operations in which the central bank decreases the money supply by selling bonds lead to a decrease in the price of bonds and an increase in the interest rate.

28. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 28 of 23 easy monetary policy interest nonsynchronization of income and spending speculation motive tight monetary policy transaction motive REVIEW TERMS AND CONCEPTS

29. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 29 of 23 THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY A P P E N D I X A THE TERM STRUCTURE OF INTEREST RATES The term structure of interest rates is the relationship among the interest rates offered on securities of different maturities. 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 higher future short-term interest rates are likely to increase. These expectations will then be reflected in current long- term interest rates.

30. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 30 of 23 THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY A P P E N D I X A TYPES OF INTEREST RATES Three-Month Treasury Bill Rate Government Bond Rate Federal Funds Rate Commercial Paper Rate Prime Rate AAA Corporate Bond Rate

31. CHAPTER 26 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 31 of 23 THE DEMAND FOR MONEY: A NUMERICAL EXAMPLE A P P E N D I X B TABLE 26B.1 Optimum Money Holdings 1 Number of Switches a 2 Average Money Holdings b 3 Average Bond Holdings c 4 Interest Earned d 5 Cost of Switching e 6 Net Profit f r = 5 percent 0$600.00$ 0.00 1300.00 15.002.0013.00 2200.00400.0020.004.0016.00 3150.00*450.0022.506.0016.50 4120.00480.0024.008.0016.00 Assumptions: Interest rate r = 0.05. Cost of switching from bonds to money equals $2 per transaction. r = 3 percent 0$600.00$ 0.00 1300.00 9.002.007.00 2200.00*400.0012.004.008.00 3150.00450.0013.506.007.50 4120.00480.0014.408.006.40 Assumptions: Interest rate r = 0.03. Cost of switching from bonds to money equals $2 per transaction. *Optimum money holdings. a That is, the number of times you sell a bond. b Calculated as 600/(col. 1 + 1). c Calculated as 600 − col. 2. d Calculated as r × col. 3, where r is the interest rate. e Calculated as t × col. 1, where t is the cost per switch ($2). f Calculated as col. 4 − col. 5