Money Demand and the Equilibrium Interest Rate Prepared by: Fernando & Yvonn Quijano

26 26 Money Demand and the Equilibrium Interest Rate PART V THE CORE OF MACROECONOMIC THEORY 26 26 CHAPTER OUTLINE Interest Rates and Bond Prices The Demand for Money The Transaction Motive The Speculation Motive The Total Demand for Money The Effects of Income and the Price Level on the Demand for Money The Equilibrium Interest Rate Supply and Demand in the Money Market Changing 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

Professor Serebryakov Makes an Economic Error Interest Rates and Bond Prices Interest The fee that borrowers pay to lenders for the use of their funds. Professor Serebryakov Makes an Economic Error Uncle Vanya by Anton Chekhov

The Demand for Money 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. The Transaction Motive transaction motive The main reason that people hold money—to buy things.

The Demand for Money The Transaction Motive  FIGURE 26.1 The Nonsynchronization of Income and Spending Income arrives only once a month, but spending takes place continuously.

The Demand for Money The Transaction Motive nonsynchronization of income and spending The mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses.

The Demand for Money The Transaction Motive  FIGURE 26.2 Jim’s Monthly Checking Account Balances: Strategy 1 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.

The Demand for Money The Transaction Motive  FIGURE 26.3 Jim’s Monthly Checking Account Balances: Strategy 2 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.

The Demand for Money The Transaction Motive  FIGURE 26.4 The Demand Curve for Money Balances 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.

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 Demand for Money 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. At any given moment, there is a demand for money—for cash and checking account balances. Although households and firms need to hold balances for everyday transactions, their demand has a limit. For both households and firms, the quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate.

ATMs and the Demand for Money The Total Demand for 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.

The Demand for Money The Effects of Income and the Price Level on the Demand for Money  FIGURE 26.5 An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right 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.

The Demand for Money The Effects of Income and the Price Level on the Demand for Money 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. 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 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.

The Equilibrium Interest Rate Supply and Demand in the Money Market  FIGURE 26.6 Adjustments 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 r0 the price of bonds would be bid up (and thus the interest rate down), and at r1 the price of bonds would be bid down (and thus the interest rate up).

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.

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.

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.

REVIEW TERMS AND CONCEPTS easy monetary policy interest nonsynchronization of income and spending speculation motive tight monetary policy transaction motive

A P P E N D I X A THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY 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.

A P P E N D I X A THE VARIOUS INTEREST 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

2 Average Money Holdingsb 3 Average Bond Holdingsc A P P E N D I X B THE DEMAND FOR MONEY: A NUMERICAL EXAMPLE TABLE 26B.1 Optimum Money Holdings 1 Number of Switchesa 2 Average Money Holdingsb 3 Average Bond Holdingsc 4 Interest Earnedd 5 Cost of Switchinge 6 Net Profitf r = 5 percent $600.00 $ 0.00 $ 0.00 $0.00 1 300.00 15.00 2.00 13.00 2 200.00 400.00 20.00 4.00 16.00 3 150.00* 450.00 22.50 6.00 16.50 4 120.00 480.00 24.00 8.00 Assumptions: Interest rate r = 0.05. Cost of switching from bonds to money equals $2 per transaction. r = 3 percent 9.00 7.00 200.00* 12.00 150.00 13.50 7.50 14.40 6.40 Assumptions: Interest rate r = 0.03. Cost of switching from bonds to 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 × col. 3, where r is the interest rate. eCalculated as t × col. 1, where t is the cost per switch ($2). fCalculated as col. 4 − col. 5