© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 22 Prepared by: Fernando Quijano and Yvonn Quijano Money Demand, the Equilibrium Interest Rate, and Monetary Policy

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Demand for Money The main concern in the study of the demand for money is: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. 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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Transactions Motive There is a trade-off between the liquidity of money and the interest income offered by other kinds of assets.There is a trade-off between the liquidity of money and the interest income offered by other kinds of assets. The transactions motive is the main reason that people hold money—to buy things.The transactions motive is the main reason that people hold money—to buy things.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Transactions Motive Simplifying assumptions in the study of the demand for money: There are only two kinds of assets available to households: bonds and 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.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 occurs at a completely uniform rate— the same amount is spent each day. Spending is exactly equal to income for the month.Spending is exactly equal to income for the month.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Nonsynchronization of Income and Spending The mismatch between the timing of money inflow and the timing of money outflow is called the nonsynchronization of income and spending.The mismatch between the timing of money inflow and the timing of money outflow is called the nonsynchronization of income and spending. Income arrives only once a month, but spending takes place continuously.Income arrives only once a month, but spending takes place continuously.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.In this case, his average money holdings would be $600.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.Month over month, his average money holdings would be $300.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Speculation Motive The speculation motive is 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.The speculation motive is 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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.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) and money demand is likely to be low (high).When interest rates are high (low) and expected to fall (rise), demand for bonds is likely to be high (low) and money demand is likely to be low (high).

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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. 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 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 demand for money.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Determinants of Money Demand The total demand for money in the economy depends on the total dollar volume of transactions made.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.The total dollar volume of transactions, in turn, depends on the total number of transactions, and the average transaction amount.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Transactions Volume and the Level of Output When output (income) rises, the total number of transactions rises, and the demand for money curve shifts to the right.When output (income) rises, the total number of transactions rises, and the demand for money curve shifts to the right.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Determinants of Money Demand Money demand is not a flow measure. Rather it is a stock variable, measured at a given point in time.Money demand is not a flow measure. Rather it is a stock variable, measured at a given point in time. Money demand answers the question: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? 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? How much of its assets a household holds in the form of money is different from how much of its income it spends during the year.How much of its assets a household holds in the form of money is different from how much of its income it spends during the year.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Equilibrium Interest Rate At r 1, amount of money in circulation is higher than households and firms want to hold. They will attempt to reduce their money holdings by buying bonds.At r 1, amount of money in circulation is higher than households and firms want to hold. They will attempt to reduce their money holdings by buying bonds.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Changing the Money Supply to Affect the Interest Rate An increase in the supply of money lowers the rate of interest.An increase in the supply of money lowers the rate of interest. To expand the money supply the fed can reduce the reserve requirement, cut the discount rate, or buy U.S. government securities in the open market.To expand the money supply the fed can reduce the reserve requirement, cut the discount rate, or buy U.S. government securities in the open market.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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 from 7 percent to 14 percent.An increase in aggregate output (income) shifts the money demand curve, which raises the equilibrium interest rate from 7 percent to 14 percent. An increase in the price level has the same effect.An increase in the price level has the same effect.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.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.Easy monetary policy refers to Fed policies that expand the money supply in an effort to stimulate the economy.