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

CHAPTER
11
Money Demand,
the Equilibrium Interest
Rate, and Monetary Policy
Appendix A and Appendix B
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 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Monetary Policy and Interest
• The previous chapter covered the money supply and
how money is created. This chapter covers the
demand for money.
• Monetary policy is the behavior of the Federal Reserve
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 11: 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:
• A household or business wants only to hold a fraction
of its financial wealth as money. or
• 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.
• 1.
Money earns no interest (or very little interest).
• 2.
Other financial assets do earn interest.
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C H A P T E R 11: 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.
• According to Keynes there were three
motives for holding money: transactions,
precautionary, and speculative. Of these
the transactions motive is most important
today
• 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 11: 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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C H A P T E R 11: 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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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
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.
• In this case, his average money holdings would be
$600. For the first half of the month Jim has more than
his average of $600 on deposit, and for the second
half of the month he has less than his average.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Money Management
• Is anything wrong
with Jim's strategy?
• Yes, Jim’s could
decide to deposit half
of his paycheck
($1,200) into his
checking account, and
buy a $600 bond with
the other half. At midmonth, 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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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Optimal Balance
• The optimal balance is the level of average
money balance that earns the consumer the
most net profit, taking into account both the
interest earned on bonds and the costs paid
for switching from bonds to money. When
interest rates are high people tend to hold very
little money.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Speculation Motive
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• 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 11: 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.
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C H A P T E R 11: 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.
• Like households, firms must manage their money.
They have payrolls to meet and purchases to make;
they receive cash and checks from sales; and many
firms that deal with the public must make change—
they need cash in the cash register. Thus, just like
Jim, firms need money to engage in ordinary
transactions.
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C H A P T E R 11: 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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‫ما هو أثر سياسة الفائدة ؟ •‬
‫إن أسعار الفائدة السائدة في السوق النقدية العامة ‪ ،‬وتلك المتعلقة‬
‫بالبنوك التجارية خاصة ‪ ،‬تكون موازية لسعر الفائدة الذي يقرره‬
‫البنك المركزي ‪ .‬وفي هذه الحالة فإن ارتفاع سعر الفائدة لدى البنك‬
‫المركزي سوف يؤدي إلى ارتفاع أسعار الفائدة أو تكلفة اإلقراض‬
‫السائدة في السوق النقدية أو التي تقررها البنوك التجارية ‪ ،‬وهذا‬
‫بالطبع يدفع العمالء إلى اإلحجام عن طلب االئتمان ويسبب ذلك‬
‫انخفاض حجم االئتمان والعكس صحيح‪.‬‬
‫‪14 of 29‬‬
‫‪Karl Case, Ray Fair‬‬
‫‪Principles of Economics, 7/e‬‬
‫‪C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and‬‬
‫‪Monetary Policy‬‬
‫‪The Total Demand for Money‬‬
‫‪© 2004 Prentice Hall Business Publishing‬‬
C H A P T E R 11: 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 volume of transactions
made.
• The total dollar volume of
transactions, in turn, depends on
the total number of transactions,
and the average transaction
amount.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Transactions Volume
and the Price Level
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• 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 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
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.
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C H A P T E R 11: 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)
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C H A P T E R 11: 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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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Equilibrium Interest Rate
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• 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 11: 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. They
will attempt to reduce
their money holdings
by buying bonds.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Equilibrium Interest Rate
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• At r2, households
don’t have enough
money to facilitate
ordinary transactions.
They will shift assets
out of bonds and into
their checking
accounts.
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C H A P T E R 11: 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 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Increases in Y and Shifts
in the Money Demand Curve
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• 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 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Looking Ahead: 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.
• Easy monetary policy refers to Fed
policies that expand the money
supply in an effort to stimulate the
economy.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Review Terms and Concepts
© 2004 Prentice Hall Business Publishing
easy monetary policy
interest
interest rate
monetary policy
nonsynchronization of income
and spending
speculation motive
tight monetary policy
transaction motive
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C H A P T E R 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:
• 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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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Appendix A: The Various
Interest Rates in the U.S. Economy
• 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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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Appendix B: The Demand for
Money: A Numerical Example
• The optimal average level of money
holdings is the amount that
maximizes the profits from money
management.
• The cost per switch multiplied by the
number of switches must be
subtracted from interest revenue to
obtain the net profit from money
management.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Appendix B: The Demand for
Money: A Numerical Example
1
2
NUMBER OF AVERAGE MONEY
SWITCHESa
HOLDINGSb
0
1
2
3
4
$600.00
300.00
200.00
150.00*
120.00
3
4
AVERAGE BOND INTEREST
HOLDINGSc
EARNEDd
r = 5 percent
$ 0.00
$ 0.00
300.00
15.00
400.00
20.00
450.00
22.50
480.00
24.00
5
COST OF
SWITCHINGe
6
NET
PROFITf
$0.00
2.00
4.00
6.00
8.00
$ 0.00
13.00
16.00
16.50
16.00
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
$ 0.00
300.00
9.00
400.00
12.00
450.00
13.50
480.00
14.40
$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.
*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 x col.3, where r is the interest rate. eCalculated as t x col.1, where t is the cost per switch ($2). fCalculated as col.4 – col.5.
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