Transcript The Equilibrium Interest Rate

Lecture 7
Money Demand and the Equilibrium Interest Rate
Interest Rates and Bond Prices
The Demand for Money
The Transaction Motive
The Speculation Motive
The Total Demand for Money
The Effects of Income and the Price Level 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 Y and Shifts in the Money Demand Curve
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Interest Rates and Bond Prices
Interest The fee that borrowers pay to lenders for
the use of their funds.
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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 interest-bearing securities, such as bonds.
The Transaction Motive
transaction motive The main reason that people
hold money—to buy things.
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The Demand for Money
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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The Demand for Money
The Transaction Motive
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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The Demand for Money
The Transaction Motive
 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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The Demand for Money
The Transaction Motive
 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.
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The Demand for Money
The Transaction Motive
 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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The Demand for Money
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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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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The Demand for Money
The Effects of Income and the Price Level on the Demand for Money
 FIGURE 11.5 An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve
to the Right
An increase in Y means that there is more economic activity. Firms are producing and selling more, and
households are earning more income and buying more. There are more transactions, for which money is
needed. As a result, both firms and households are likely to increase their holdings of money balances at a
given interest rate.
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The Demand for Money
The Effects of Income and the Price Level on the Demand for Money
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.
TABLE 11.1 Determinants of Money Demand
1. The interest rate: r (The quantity of money demanded is a negative function of the
interest rate.)
2. The dollar volume of transactions
a. Aggregate output (income): Y (An increase in Y shifts the money demand curve to
the right.)
b. The price level: P (An increase in P shifts the money demand curve to the right.)
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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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The Equilibrium Interest Rate
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), and at r1 the price of bonds
would be bid down (and thus the
interest rate up).
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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
An increase in the supply of money
from
to
lowers the rate of
interest from 7 percent to 4
percent.
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The Equilibrium Interest Rate
Increases in Y and Shifts in the Money Demand Curve
 FIGURE 11.8 The Effect of
an Increase in Income on the
Interest Rate
An increase in aggregate output
(income) shifts the money demand
curve from
to , which raises
the equilibrium interest rate from 4
percent to 7 percent.
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Looking Ahead: The Federal Reserve and Monetary Policy
tight monetary policy Fed policies that contract
the money supply and thus raise interest rates in
an effort to restrain the economy.
easy monetary policy Fed policies that expand
the money supply and thus lower interest rates in
an effort to stimulate the economy.
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REVIEW TERMS AND CONCEPTS
easy monetary policy
interest
nonsynchronization of income
and spending
speculation motive
tight monetary policy
transaction motive
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