MONEY DEMAND, THE EQUILIBRIUM INTEREST RATE, AND MONETARY POLICY Chapter 23 1

MONEY DEMAND, THE EQUILIBRIUM INTEREST RATE, AND MONETARY POLICY monetary policy The behavior of the Central Bank concerning the money supply interest The fee that borrowers pay to lenders for the use of their funds interest rate The annual interest payment on a loan expressed as a percentage of the loan Equal to the amount of interest received per year divided by the amount of the loan 2

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 total amount of financial assets are divided into two; money and interest-bearing securities 3

THE DEMAND FOR MONEY How much money to hold involves a trade-off between the liquidity of money and the interest income offered by other kinds of assets THE TRANSACTION MOTIVE transaction motive The main reason that people hold money instead of interest-bearing assets—to buy things 4

THE DEMAND FOR MONEY There are only two kinds of assets available to households: bonds and money The interest rate represents the opportunity cost of holding money and therefore not holding bonds, which pay interest The higher the interest rate is, the higher the opportunity cost of holding money and the less money people will want to hold When interest rates are high, people want to take advantage of the high return on bonds, so they choose to hold very little money 5

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The quantity of money demanded is a function of the interest rate At higher interest rates, bonds are much more attractive than money, so people hold less money because they must make a large sacrifice in interest (that is the “price” of money) for the amount of money they hold The money demand slopes downward There is an inverse relationship between the interest rate and the quantity of money demanded 7

THE DEMAND FOR MONEY Another theory to explain why the quantity of money households desire to hold may rise when interest rates fall and fall when interest rate rise involves household expectations and the relationship of interest rates to bond values When market interest rates fall, bond values rise; when market interest rates rise, bond values fall 8

THE DEMAND FOR MONEY Suppose I bought an 8% bond a year ago for 1000 TL Now suppose the market interest rate rises to 10% If I offered to sell my bond for 1000 TL, no one would buy it because anyone can buy a new bond and earn 10% in the market instead of 8% of my bond If I lower the price, this lower price will increase the actual yield to the buyer of my bond Suppose I sell my bond for 500 TL On original, the bond is paying 8%, that is 80 TL per year However, for the actual taker of the bond at 500 TL, it comes 16% percent of his investment in the bond (500 TL X 0.16 = 80 TL) If you bought the same bond from me for about 800 TL, it would pay you 10% interest (800 TL x 0.1 =80 TL) 9

THE DEMAND FOR MONEY THE SPECULATION MOTIVE speculation motive One reason for holding bonds instead of money: 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 10

THE DEMAND FOR MONEY 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) 11

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 12

THE DEMAND FOR MONEY As previously stated, the money demand curve is a function of the interest rate There are other factors besides the interest rate that influence total desired money holdings One is the value of transactions made during a given period of time The total demand for money in the economy depends on the total volume of transactions made 13

THE DEMAND FOR MONEY The total volume of transactions in the economy, in turn, depends on two things: the total number of transactions and the average transactions amount A reasonable indicator for the total number of transactions is aggregate output (income) Y A rise in aggregate output means firms producing and selling more, more people are on payrolls, and household incomes are higher There are more transactions Firms and households will hold more money Thus increase in aggregate output (income) will increase the demand for money 14

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THE DEMAND FOR MONEY For a given interest rate, a higher level of output means an increase in the number of transactions and more demand for money The money demand curve shifts to the right when Y rises Similarly, a decrease in Y means a decrease in the number of transactions and a lower demand for money The money demand curve shifts to the left when Y falls 16

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 amount of each transaction In turn, the average amount of each transaction depends on prices, or instead, on the price level If all prices were to double, firms and households would need more money balances to carry out their day-to-day transactions-each transaction would require twice as much money 17

THE DEMAND FOR MONEY Increases in the price level shift the money demand curve to the right Decreases in the price level shift the money demand curve to the left Even though the number of transactions may not have changed, the quantity of money needed to engage in them has 18

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THE DEMAND FOR MONEY Some Common Pitfalls Money demand is not a flow measure Instead, it is a stock variable, measured at a given point in time Many people think of money demand and saving as roughly the same—they are not Recall the difference between a shift in a demand curve and a movement along the curve Changes in the interest rate cause movements along the curve—changes in the quantity of money demanded 20

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

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THE CENTRAL BANK AND MONETARY POLICY The Central Bank’s use of its power to influence events in the goods market, as well as in the money market, is the center of the government’s monetary policy tight monetary policy Central Bank policies that contract the money supply in an effort to restrain the economy easy monetary policy Central Bank policies that expand the money supply in an effort to stimulate the economy 25