23 © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Money Demand, the Equilibrium Interest Rate, and Monetary Policy Prepared by: Fernando Quijano and Yvonn Quijano Appendix A and Appendix B

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 29 Monetary Policy and Interest 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 29 The Demand for Money The main concern in the study of the demand for money is: 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 29 The Transaction Motive There is a trade-off between the liquidity of money and the interest income offered by other kinds of assets. The transaction motive is the main reason that people hold money—to buy things.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 29 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 29 The 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 is called the nonsynchronization of income and spending. Income arrives only once a month, but spending takes place continuously.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 29 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 29 Money Management Jim 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 29 The Optimal Balance There is a level of average money holdings that earns Jim the most profit, taking into account both the interest earned on bonds and the cost paid for switching from bonds to money. This level is his optimal balance. An increase in the interest rate lowers the optimal money balance. People want to take advantage of the high return on bonds, so they choose to hold very little money.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 29 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 29 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. When interest rates are high (low) and expected to fall (rise), demand for bonds is likely to be high (low) thus money demand is likely to be low (high).

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 29 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 29 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 29 Transactions Volume and 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 29 Transactions Volume and the Price Level When output (income) rises, the total number of transactions rises, and the demand for money curve shifts to the right.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 29 Transactions Volume and the Price Level 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 29 The Determinants of Money Demand: Review Money demand is a stock variable, measured at a given point in time. 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)

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 29 The Determinants of Money 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?

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 29 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 29 The Equilibrium Interest Rate At r 1, 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 29 The Equilibrium Interest Rate At r 2, households don’t have enough money to facilitate ordinary transactions. They will shift assets out of bonds and into their checking accounts.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 29 Changing the Money Supply to Affect the Interest Rate An increase in the supply of money lowers the rate of interest.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 29 Increases in Y and Shifts in 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 29 Looking Ahead: The Federal Reserve 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 29 Review Terms and Concepts easy monetary policy easy monetary policy interest rate interest rate monetary policy monetary policy nonsynchronization of income and spending nonsynchronization of income and spending speculation motive speculation motive tight monetary policy tight monetary policy transaction motive transaction motive

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 29 Appendix A: The Various Interest 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 29 Appendix 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

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 29 Appendix B: The Demand for Money: 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.

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 29 Appendix B: The Demand for Money: A Numerical Example 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$600.00$ * Assumptions: Interest rate r = Cost of switching from bonds into money equals $2 per transaction. r = 3 percent 0$600.00$ * Assumptions: Interest rate r = Cost of switching from bonds into 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 x col.3, where r is the interest rate. e Calculated as t x col.1, where t is the cost per switch ($2). f Calculated as col.4 – col.5.