1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 11 Chapter Money Demand, the Equilibrium Interest Rate, and Monetary Policy

2. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 26 Chapter Outline 11 Money Demand, the Equilibrium Interest Rate, and Monetary Policy The Demand for Money The Transaction Motive Money Management and the Optimal Balance The Speculation Motive The Total Demand for Money Transactions Volume and the Price Level The Determinants of Money Demand: Review 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

3. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 26 MONEY DEMAND, THE EQUILIBRIUM INTEREST RATE, AND MONETARY POLICY monetary policy The behavior of the Federal Reserve 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.

4. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 26 If a $1,000 bond pays $100 per year, the interest rate on the bond is calculated as follows: a.$1,000 / $100 = $10 b.$100 c.$1,000 * $100 = $10,0000 d.$100 / $1,000 = 10%

5. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 26 If a $1,000 bond pays $100 per year, the interest rate on the bond is calculated as follows: a.$1,000 / $100 = $10 b.$100 c.$1,000 * $100 = $10,0000 d.$100 / $1,000 = 10%

6. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 26 THE DEMAND FOR MONEY transaction motive The main reason that people hold money—to buy things. THE TRANSACTION MOTIVE 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.

7. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 26 THE DEMAND FOR MONEY Assumptions  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.

8. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 26 THE DEMAND FOR MONEY Assumptions FIGURE 11.1 The Nonsynchronization of Income and Spending

9. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 26 THE DEMAND FOR MONEY 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.

10. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 26 THE DEMAND FOR MONEY MONEY MANAGEMENT AND THE OPTIMAL BALANCE FIGURE 11.2 Jim’s Monthly Checking Account Balances: Strategy 1

11. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 26 Jim receives $1,200 per month (30 days) and spends $40 each day. What is his average money balance? a.$40. b.$30. c.$600. d.$1,200.

12. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 26 Jim receives $1,200 per month (30 days) and spends $40 each day. What is his average money balance? a.$40. b.$30. c.$600. d.$1,200.

13. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 26 THE DEMAND FOR MONEY FIGURE 11.3 Jim’s Monthly Checking Account Balances: Strategy 2

14. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 26 THE DEMAND FOR MONEY FIGURE 11.4 The Demand Curve for Money Balances When interest rates are high, people want to take advantage of the high return on bonds, so they choose to hold very little money. The Optimal Balance

15. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 26 Assume that there are no management costs associated with buying and selling bonds. What is the impact of an increase in the interest rate on money holdings and interest revenue? a.Both money holdings and interest revenue would rise. b.Both money holdings and interest revenue would decline. c.Money holdings would rise and interest revenue would decline. d.Money holdings would decline, and interest revenue would rise.

16. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 26 Assume that there are no management costs associated with buying and selling bonds. What is the impact of an increase in the interest rate on money holdings and interest revenue? a.Both money holdings and interest revenue would rise. b.Both money holdings and interest revenue would decline. c.Money holdings would rise and interest revenue would decline. d.Money holdings would decline, and interest revenue would rise.

17. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 26 THE DEMAND FOR MONEY When market interest rates fall, bond values rise; when market interest rates rise, bond values fall. 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. THE SPECULATION MOTIVE

18. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 26 THE DEMAND FOR MONEY When market interest rates fall, bond values rise; when market interest rates rise, bond values fall. 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). THE SPECULATION MOTIVE

19. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 26 THE DEMAND FOR MONEY 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 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.

20. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 26 Which of the following is a better measure of the opportunity cost of holding money balances? a.The demand for money curve. b.The interest rate. c.The transactions motive. d.The optimal money balance.

21. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 26 Which of the following is a better measure of the opportunity cost of holding money balances? a.The demand for money curve. b.The interest rate. c.The transactions motive. d.The optimal money balance.

22. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 26 THE DEMAND FOR MONEY TRANSACTIONS VOLUME AND THE PRICE LEVEL FIGURE 11.5An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right

23. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 26 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. Increases in the price level shift the money demand curve to the right, and 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. 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.

24. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 26 The demand for money increases when: a.Both the dollar volume of transactions and the average transaction amount increase. b.Both the dollar volume of transactions and the average transaction amount decrease. c.The dollar volume of transactions increases and the average transaction amount decreases. d.The dollar volume of transactions decreases and the average transaction amount increases.

25. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 26 The demand for money increases when: a.Both the dollar volume of transactions and the average transaction amount increase. b.Both the dollar volume of transactions and the average transaction amount decrease. c.The dollar volume of transactions increases and the average transaction amount decreases. d.The dollar volume of transactions decreases and the average transaction amount increases.

26. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 26 THE DEMAND FOR MONEY THE DETERMINANTS OF MONEY DEMAND: REVIEW TABLE 11.1 Determinants of Money Demand 1.The interest rate: r (negative effect causes downward-sloping money demand) 2.The dollar volume of transactions (positive effects shift the money demand curve) a. Aggregate output (income): Y (positive effect: money demand shifts right when Y increases) b. The price level: P (positive effect: money demand shifts right when P increases)

27. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 26 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.

28. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 26 Fill in the blanks. The demand for goods and services is a ______________ and the demand for money is a ______________. a.flow variable; stock variable b.stock variable; flow variable c.flow variable; flow variable d.stock variable; stock variable.

29. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 26 Fill in the blanks. The demand for goods and services is a ______________ and the demand for money is a ______________. a.flow variable; stock variable b.stock variable; flow variable c.flow variable; flow variable d.stock variable; stock variable.

30. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 26 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. We are now in a position to consider one of the key questions in macroeconomics: How is the interest rate determined in the economy?

31. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 26 THE EQUILIBRIUM INTEREST RATE SUPPLY AND DEMAND IN THE MONEY MARKET FIGURE 11.6Adjustments in the Money Market If the interest rate is initially high enough to create an excess supply of money, the interest rate will immediately fall, discouraging people from moving out of money and into bonds. If the interest rate is initially low enough to create an excess demand for money, the interest rate will immediately rise, discouraging people from moving out of bonds and into money.

32. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 26 When the interest rate is above the equilibrium interest rate: a.People will move out of bonds and into money—hold larger cash balances. b.The quantity of money demanded is too high to achieve equilibrium. c.The quantity of money demanded is greater than the quantity of money supplied. d.There is more money in circulation than households and firms want to hold.

33. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 26 When the interest rate is above the equilibrium interest rate: a.People will move out of bonds and into money—hold larger cash balances. b.The quantity of money demanded is too high to achieve equilibrium. c.The quantity of money demanded is greater than the quantity of money supplied. d.There is more money in circulation than households and firms want to hold.

34. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 34 of 26 THE EQUILIBRIUM INTEREST RATE CHANGING THE MONEY SUPPLY TO AFFECT THE INTEREST RATE FIGURE 11.7The Effect of an Increase in the Supply of Money on the Interest Rate

35. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 35 of 26 An increase in the money supply, without a change in the demand for money will: a.Increase the equilibrium interest rate. b.Decrease the equilibrium interest rate. c.Result in an excess demand for money. d.Decrease the quantity of money demanded.

36. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 36 of 26 An increase in the money supply, without a change in the demand for money will: a.Increase the equilibrium interest rate. b.Decrease the equilibrium interest rate. c.Result in an excess demand for money. d.Decrease the quantity of money demanded.

37. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 37 of 26 THE EQUILIBRIUM INTEREST RATE INCREASES IN Y AND SHIFTS IN THE MONEY DEMAND CURVE FIGURE 11.8The Effect of an Increase in Income on the Interest Rate An increase in Y shifts the money demand curve to the right. An increase in the price level is like an increase in Y in that both events increase the demand for money. The result is an increase in the equilibrium interest rate. A decrease in the price level leads to a decrease in the equilibrium interest rate.

38. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 38 of 26 LOOKING AHEAD: THE FEDERAL RESERVE AND MONETARY POLICY tight monetary policy Fed policies that contract the money supply in an effort to restrain the economy. easy monetary policy Fed policies that expand the money supply in an effort to stimulate the economy. The Fed’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.

39. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 39 of 26 If the Fed wants to maintain the interest rate constant, it will have to: a.Increase the money supply when the demand for money increases. b.Increase the money supply when the demand for money decreases. c.Leave the money supply unchanged regardless of changes in the demand for money. d.Decrease the reserve requirement when the demand for money shifts to the left.

40. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 40 of 26 If the Fed wants to maintain the interest rate constant, it will have to: a.Increase the money supply when the demand for money increases. b.Increase the money supply when the demand for money decreases. c.Leave the money supply unchanged regardless of changes in the demand for money. d.Decrease the reserve requirement when the demand for money shifts to the left.

41. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 41 of 26 easy monetary policy interest interest rate monetary policy nonsynchronization of income and spending speculation motive tight monetary policy transaction motive REVIEW TERMS AND CONCEPTS

42. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 42 of 26 THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY Appendix A 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 future short-term interest rates are reflected in current long-term interest rates.

43. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 43 of 26 Appendix A TYPES OF INTEREST RATES Three-Month Treasury Bill Rate Government Bond Rate Federal Funds Rate Commercial Paper Rate Prime Rate AAA Corporate Bond Rate

44. CHAPTER 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 44 of 26 Appendix B THE DEMAND FOR MONEY: A NUMERICAL EXAMPLE TABLE 11B.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$600.00$ 0.00 1300.00 15.002.0013.00 2200.00400.0020.004.0016.00 3150.00*450.0022.506.0016.50 4120.00480.0024.008.0016.00 Assumptions: Interest rate r = 0.05. Cost of switching from bonds into money equals $2 per transaction. r = 3 percent 0$600.00$ 0.00 1300.00 9.002.007.00 2200.00*400.0012.004.008.00 3150.00450.0013.506.007.50 4120.00480.0014.408.006.40 Assumptions: Interest rate r = 0.03. 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 × 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