1 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education CHAPTER OUTLINE 26 Money Demand and the Equilibrium Interest Rate Interest Rates and Bond Prices The Demand for Money The Transaction Motive The Speculation Motive The Total Demand for Money The Effect of Nominal Income 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 P Y and Shifts in the Money Demand Curve Zero Interest Rate Bound 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

2 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education Interest Rates and Bond Prices interest The fee that borrowers pay to lenders for the use of their funds. Firms and governments borrow funds by issuing bonds, and they pay interest to the lenders that purchase the bonds. When interest rates rise, the prices of existing bonds fall.

3 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education transaction motive The main reason that people hold money—to buy things. 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 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.

4 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education Income arrives only once a month, but spending takes place continuously.  FIGURE 26.1 The Nonsynchronization of Income and Spending The Demand for Money The Transaction Motive

5 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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 The Demand for Money The Transaction Motive

6 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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 The Demand for Money The Transaction Motive

7 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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 The Demand for Money The Transaction Motive

8 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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 Speculation Motive

9 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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. The Demand for Money The Total Demand for Money

10 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education  FIGURE 26.5 An Increase in Nominal Aggregate Output (Income) (P Y) Shifts the Money Demand Curve to the Right The Demand for Money The Effect of Nominal Income on the Demand for Money

11 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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.Aggregate nominal output (income) P Y a. Real aggregate output (income): Y (An increase in Y shifts the money demand curve to the right.) b. The aggregate price level: P (An increase in P shifts the money demand curve to the right.) The Demand for Money The Effect of Nominal Income on the Demand for Money The demand for money depends negatively on the interest rate, r, and positively on real income, Y, and the price level, P.

12 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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

13 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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). 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 The Equilibrium Interest Rate Supply and Demand in the Money Market

14 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education  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 M S 0 to M S 1 lowers the rate of interest from 7 percent to 4 percent. The Equilibrium Interest Rate Changing the Money Supply to Affect the Interest Rate

15 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education  FIGURE 26.8 The Effect of an Increase in Nominal Income (P Y) on the Interest Rate An increase in nominal income (P Y) shifts the money demand curve from M d 0 to M d 1, which raises the equilibrium interest rate from 4 percent to 7 percent. The Equilibrium Interest Rate Increases in P Y and Shifts in the Money Demand Curve

16 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education tight monetary policy CB policies that contract the money supply and thus raise interest rates in an effort to restrain the economy. easy monetary policy CB policies that expand the money supply and thus lower interest rates in an effort to stimulate the economy. Looking Ahead: The Central Bank and Monetary Policy

17 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education easy monetary policy interest nonsynchronization of income and spending speculation motive tight monetary policy transaction motive R E V I E W T E R M S A N D C O N C E P T S

18 of 25 PART V The Core of Macroeconomic Theory © 2012 Pearson Education 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$600.00$ * Assumptions: Interest rate r  Cost of switching from bonds to money equals $2 per transaction. r  3 percent 0$600.00$ * Assumptions: Interest rate r  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. CHAPTER 26 APPENDIX B The Demand For Money: A Numerical Example