Transcript interest rate

Chapter
11
Money Demand,
the Equilibrium Interest
Rate, and Monetary Policy
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
Money Demand,
the Equilibrium Interest
Rate, and Monetary Policy
11
Chapter Outline
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
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
interest received per year
Interest rate 
x100
amount of the loan
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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%
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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%
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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 interestbearing securities, such as bonds.
THE TRANSACTION MOTIVE
transaction motive The main reason
that people hold money—to buy things.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
THE DEMAND FOR MONEY
Assumptions
FIGURE 11.1 The Nonsynchronization of Income and Spending
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
THE DEMAND FOR MONEY
MONEY MANAGEMENT AND THE OPTIMAL
BALANCE
FIGURE 11.2 Jim’s Monthly Checking Account Balances: Strategy 1
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
THE DEMAND FOR MONEY
FIGURE 11.3 Jim’s Monthly Checking Account Balances: Strategy 2
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
THE DEMAND FOR MONEY
The Optimal Balance
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
THE DEMAND FOR MONEY
THE SPECULATION MOTIVE
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 interestbearing 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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
THE DEMAND FOR MONEY
THE SPECULATION MOTIVE
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).
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
THE DEMAND FOR MONEY
TRANSACTIONS VOLUME AND THE PRICE LEVEL
FIGURE 11.5 An Increase in Aggregate Output (Income) (Y) Will
Shift the Money Demand Curve to the Right
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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.
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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)
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
THE EQUILIBRIUM INTEREST RATE
SUPPLY AND DEMAND 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.
FIGURE 11.6 Adjustments in the Money Market
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
THE EQUILIBRIUM INTEREST RATE
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
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
THE EQUILIBRIUM INTEREST RATE
INCREASES IN Y AND SHIFTS IN THE MONEY
DEMAND CURVE
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.
FIGURE 11.8 The Effect of an Increase in Income
on the Interest Rate
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
LOOKING AHEAD: THE FEDERAL RESERVE
AND MONETARY POLICY
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.
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
REVIEW TERMS AND CONCEPTS
easy monetary policy
interest
interest rate
monetary policy
nonsynchronization of income
and spending
speculation motive
tight monetary policy
transaction motive
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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.
People’s expectations of future short-term interest
rates are reflected in current long-term interest rates.
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
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
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CHAPTER 11: Money Demand, the Equilibrium
Interest Rate, and Monetary Policy
Appendix B
THE DEMAND FOR MONEY: A NUMERICAL EXAMPLE
TABLE 11B.1 Optimum Money Holdings
1
NUMBER OF
SWITCHESa
0
1
2
3
4
2
AVERAGE MONEY
HOLDINGSb
$600.00
300.00
200.00
150.00*
120.00
3
AVERAGE BOND
HOLDINGSc
r = 5 percent
$ 0.00
300.00
400.00
450.00
480.00
4
INTEREST
EARNEDd
5
COST OF
SWITCHINGe
$ 0.00
15.00
20.00
22.50
24.00
6
NET
PROFITf
$0.00
2.00
4.00
6.00
8.00
$ 0.00
13.00
16.00
16.50
16.00
$0.00
2.00
4.00
6.00
8.00
$ 0.00
7.00
8.00
7.50
6.40
Assumptions: Interest rate r = 0.05. Cost of switching from bonds into money equals $2 per transaction.
0
1
2
3
4
$600.00
300.00
200.00*
150.00
120.00
r = 3 percent
$ 0.00
300.00
400.00
450.00
480.00
$ 0.00
9.00
12.00
13.50
14.40
Assumptions: Interest rate r = 0.03. Cost of switching from bonds into 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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