1. Money Demand and the Equilibrium Interest Rate11
CHAPTER OUTLINE
Interest Rates and Bond Prices
The Demand for Money
Money Demand and the Equilibrium Interest Rate
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
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2. 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.
Bonds are issued with a face value, typically in denominations of $1,000. They come with a maturity date—or the date when the face value of the bond is paid out, and they offer a fixed yearly payment, known as a coupon.
A key relationship that we will use in this chapter is that market-determined prices of existing bonds and interest rates are inversely related.
Given a bond’s market-determined price, its face value, its maturity, and its coupon, the interest rate, or yield, on that bond can be calculated. Interest rates are thus indirectly determined by the bond market.
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3. Professor Serebryakov Makes an Economic Error
E C O N O M I C S I N P R A C T I C E
Professor Serebryakov Makes an Economic Error
In Chekhov’s play Uncle Vanya, Alexander Vladimirovitch Serebryakov, a retired professor, but apparently not of economics, calls his household together to propose the following:
…Our estate yields on an average not more than two per cent, on its capital value. I propose to sell it. If we invest the money in suitable securities, we should get from four to five per cent, and I think we might even have a few
thousand roubles to spare…
If an investor in Russia can earn 5 percent on these securities, why would he or she buy an estate earning only 2 percent? The price of the estate would have to fall until the return to the investor was 5 percent.
THINKING PRACTICALLY
1. What would happen to the value of the estate if the interest rate on the securities that Professor Serebryakov is talking about fell?
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4. عمجتي It arrives once a month at the beginning of the month.
Assumptions:
To keep our analysis of the demand for money clear, we need a few simplifying assumptions. First, we assume that there are only two kinds of assets available to households: bonds and money. By “bonds” we mean interest-bearing securities of all kinds. As noted above, we are assuming that
there is only one type of bond and only one market-determined interest rate. By “money”we mean currency in circulation and deposits in checking accounts that do not pay interest.
Second, we assume that income for the typical household is “bunched up.”
عمجتي It arrives once a month at the beginning of the month.
Finally, we assume that spending for the month is equal to income for the
month.
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5. The Demand for Money
As we shall see, the interest rate and nominal income influence how much money households and firms choose to hold.
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. Not How much income would you like to earn?
**How much money to hold involves a trade-off between the liquidity of
money and the interest income offered by other kinds of assets.
transaction motive The main reason that people hold money—to buy things.
nonsynchronization of income and spending نمازتم ريغThe mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses.
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6. The Transaction Motive
 FIGURE 11.1 The Nonsynchronization of Income and Spending
Income arrives only once a month, but spending takes place continuously.
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7. In this case, his average balance would be $600.
 FIGURE 11.2 Jim’s Monthly Checking Account Balances: Strategy 1
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.
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8.  FIGURE 11.3 Jim’s Monthly Checking Account Balances: Strategy 2
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.
There is a level of average money balances that earns Jim the most profit, taking into account both the interest earned on bonds and the costs paid for switching from bonds to money. This level is his optimal balance.
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9. So, There is an inverse relationship between the interest rate and the
The higher the interest rate, 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
So, There is an inverse relationship between the interest rate and the
quantity of money demanded.
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10.  FIGURE 11.4 The Demand Curve for Money Balances
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.
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11. The Speculation Motive
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.
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12. 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.
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13. ATMs and the Demand for Money
E C O N O M I C S I N P R A C T I C E
ATMs and the Demand for Money
Italy makes a great case study of the effects of the spread of ATMs on the demand for money. In Italy, virtually all checking accounts pay interest. What doesn’t pay interest is cash.
The study found that the demand for cash responds to changes in the interest rate paid on checking accounts. The higher the interest rate, the less cash held.
In other words, when the interest rate on checking accounts rises, people go to ATM machines more often and take out less in cash each time, thereby keeping, on average, more in checking accounts earning the higher interest rate.
THINKING PRACTICALLY
1. Suppose most or all ATM machines increased the fee they charged per transaction. What would this do to the transaction demand for money?
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14. The Effect of Nominal Income on the Demand for Money
 FIGURE 11.5 An Increase in Nominal Aggregate Output (Income) (P •Y) Shifts the Money Demand Curve to the Right
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15. The demand for money depends negatively on the interest rate, r, and positively on real income, Y, and the price level, P.
TABLE 11.1 Determinants of Money Demand
The interest rate: r (The quantity of money demanded is a negative function of the interest rate.)
Aggregate nominal output (income) P • Y
Real aggregate output (income): Y (An increase in Y shifts the money demand curve to the right.)
The aggregate price level: P (An increase in P shifts the money demand curve to the right.)
Thus an increase in , the aggregate price level, increases the demand for money, as does an increase in , real aggregate income. Table summarizes everything we have said about the demand for money. The demand for money depends negatively on the interest rate, , and positively on real income, , and the price level, P.
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16. 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.
At the equilibrium interest rate r* the demand for bonds by households and firms is equal to the supply.
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17. manipulation of the amount of reserves in the economy. Because we are
We saw in Chapter 10 that the Fed controls the money supply through its
manipulation of the amount of reserves in the economy. Because we are
assuming that the Fed’s money supply behavior does not depend on the interest rate, the money supply curve is a vertical line. In other words, we are assuming that the Fed uses its three tools (the required reserve ratio, he discount rate, and open market operations) to achieve its fixed target
for the money supply.
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18. Supply and Demand in the Money Market
 FIGURE 11.6 Adjustments in the Money Market
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 r0 the price of bonds would be bid up (and thus the interest rate down).
At r1 the price of bonds would be bid down (and thus the interest rate up).
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19. Changing the Money Supply to Affect the Interest Rate
 FIGURE 11.7 The Effect of an Increase in the Supply of Money on the Interest Rate
An increase in the supply of
money from MS to MS lowers the
0 1
rate of interest from 7 percent to 4 percent. Also lowers the supply for bonds hence, increasing their price.
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20. Increases in P • Y and Shifts in the Money Demand Curve
 FIGURE 11.8 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 Md0 to Md1, which raises the equilibrium interest rate from 4 percent to 7 percent. Remember that
(P * Y )can change because the price level P changes or because real income Y
changes (or both).
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21. Zero Interest Rate Bound
By the middle of 2008 the Fed had driven the short-term interest rate close to zero, and it remained at essentially zero through the time of this writing (March ).
The Fed does this, of course, by increasing the money supply until the intersection of the money supply at the demand for money curve is at an interest rate of roughly zero.
The Fed cannot drive the interest rate lower than zero, preventing it from
stimulating the economy further.
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22. Looking Ahead
One of the main aims of this chapter and the last one has been to explain how the Fed can change the interest rate and the money supply through open market operations.
We have not yet discussed, however, why the Fed might want to change the interest rate. We have also not considered the determination of the aggregate price level. We discuss both of these issues in the next chapter. It is the key chapter regarding the core of macro theory.
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23. R E V I E W T E R M S A N D C O N C E P T S
easy monetary policy
interest
nonsynchronization of income and spending speculation motive
tight monetary policy transaction motive
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24. CHAPTER 11 APPENDIX A The Various Interest Rates in the U.S. Economy
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.
Fed behavior may directly affect people’s expectations of the future short-term
rates, which will then affect long-term rates.
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25. The Various Interest Rates in the U.S. Economy
Types of Interest Rates
Three-Month Treasury Bill Rate Probably the most widely followed short-term interest rate.
Government Bond Rate There are 1-year bonds, 2-year bonds, and so on, up to year bonds. Bonds of different terms have different interest rates.
Federal Funds Rate The rate banks are charged to borrow reserves from other banks. Generally a 1-day rate on which the Fed has the most effect through its open market operations.
Commercial Paper Rate Short-term corporate IOUs that offer a designated rate of interest depending on the financial condition of the firm and the maturity date of the IOU.
Prime Rate A benchmark that banks often use in quoting interest rates to their customers depending on the cost of funds to the bank; it moves up and down with changes in the economy.
AAA Corporate Bond Rate Classified by various bond dealers according to their risk. Bonds have a longer maturity than commercial paper. The interest rate on bonds rated AAA is the triple A corporate bond rate, the rate that the least risky firms pay on the bonds that they issue.
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26. Average Money Holdingsb
CHAPTER 11 APPENDIX B
The Demand For Money: A Numerical Example
TABLE 11B.1 Optimum Money Holdings 1
Number of Switchesa 2
Average Money Holdingsb 3
Average Bond Holdingsc
r  5 percent 4
Interest Earnedd 5
Cost of Switchinge 6
Net Profitf
$600.00
$ 0.00
$ 0.00
$0.00 1
300.00
15.00
2.00
13.00 2
200.00
400.00
20.00
4.00
16.00 3
150.00*
450.00
22.50
6.00
16.50 4
120.00
480.00
24.00
8.00
Assumptions: Interest rate r  Cost of switching from bonds to money equals $2 per transaction.
r  3 percent
$600.00
$ 0.00
$ 0.00
$0.00 1
300.00
9.00
2.00
7.00 2
200.00*
400.00
12.00
4.00
8.00 3
150.00
450.00
13.50
6.00
7.50 4
120.00
480.00
14.40
6.40
Assumptions: Interest rate r  Cost of switching from bonds to money equals $2 per transaction.
*Optimum money holdings.aThat is, the number of times you sell a bond.bCalculated as 600/(col. 1  1).cCalculated as 600  col. 2.
dCalculated as r  col. 3, where r is the interest rate.eCalculated as t  col. 1, where t is the cost per switch ($2).fCalculated as col. 4  col. 5.
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