Transcript Money Demand, the Equilibrium Interest Rate, and Monetary Policy

CHAPTER
23
Money Demand,
the Equilibrium Interest
Rate, and Monetary Policy
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Monetary Policy and Interest
• Monetary policy is the behavior of the
Central Bank concerning the money
supply.
• Interest is the fee that borrowers pay to
lenders for the use of their funds.
• Interest rate is the annual interest
payment on a loan expressed as a
percentage of the loan.
interest received per year
Interest rate 
x100
amount of the loan
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Demand for Money
• 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 interestbearing securities, such as bonds.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Transaction Motive
• There is a trade-off between the
liquidity of money and the interest
income offered by other kinds of
assets.
• The transaction motive is the main
reason that people hold money—to
buy things.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Transaction Motive
Simplifying assumptions in the study of the
demand for 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.
• 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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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The 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 is called the
nonsynchronization of
income and spending.
• Income arrives only once a month, but
spending takes place continuously.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Money Management
• Selim 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.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Money Management
• Selim 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.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Optimal Balance
• There is a level of average money holdings
that earns Selim 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.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Speculation Motive
© 2004 Prentice Hall Business Publishing
• The speculation motive:
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.
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Speculation Motive
• If someone buys a 10-year bond with a
fixed rate of 10%, and a newly issued 10year 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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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
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.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Total 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 quantity of money
demanded.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Transactions Volume
and the Price Level
• The total demand for money in the
economy depends on the total dollar
value of transactions made.
• The total dollar volume of
transactions, in turn, depends on
aggregate income and overall price
level.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Transactions Volume
and the Price Level
© 2004 Prentice Hall Business Publishing
• When output
(income) rises, the
total number of
transactions rises,
and the demand for
money curve shifts
to the right.
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Transactions Volume
and the Price Level
• When the price level rises, the
quantity of money needed to engage
in transactions rises, and the
demand for money curve shifts to the
right.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Determinants of
Money Demand: Review
Determinants of Money Demand
1. The interest rate: r (negative effect)
2. The dollar volume of transactions (positive effect)
a. Aggregate output (income): Y (positive effect)
b. The price level: P (positive effect)
• Money demand is a stock variable,
measured at a given point in time.
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Determinants of
Money Demand: Review
• 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?
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Karl Case, Ray Fair
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Equilibrium Interest Rate
© 2004 Prentice Hall Business Publishing
• 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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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Equilibrium Interest Rate
© 2004 Prentice Hall Business Publishing
• At r1, the amount of
money in circulation is
higher than
households and firms
wish to hold. Interest
rates must fall to
encourage people to
hold more money and
fewer bonds.
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Equilibrium Interest Rate
© 2004 Prentice Hall Business Publishing
• At r2, households
don’t have enough
money to facilitate
ordinary transactions.
People wil sell bonds
in order to increase
their money holdings.
This drives down
bond prices and
causes interest rates
to rise.
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Changing the Money
Supply to Affect the Interest Rate
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• An increase in the
supply of money
lowers the rate of
interest.
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Increases in Y and Shifts
in the Money Demand Curve
© 2004 Prentice Hall Business Publishing
• An increase in
aggregate output
(income) shifts the
money demand curve,
which raises the
equilibrium interest rate.
• An increase in the price
level has the same
effect.
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C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Looking Ahead: Central Bank and
Monetary Policy
• Tight monetary policy refers to the
CB policies that contract the money
supply in an effort to restrain the
economy.
• Easy monetary policy refers to the
CB policies that expand the money
supply in an effort to stimulate the
economy.
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Karl Case, Ray Fair
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