CHAPTER 11 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 1 of 23

PowerPoint Lectures for

Principles of Macroeconomics, 9e

By

Karl E. Case, Ray C. Fair & Sharon M. Oster

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PART III THE CORE OF MACROECONOMIC THEORY

11

© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster

Money Demand and

the EquilibriumInterest Rate

Fernando & Yvonn Quijano

Prepared by:

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11

Interest Rates and Bond Prices

The Demand for MoneyThe Transaction MotiveThe Speculation MotiveThe Total Demand for MoneyThe Effects of Income and the Price

Level on the Demand for Money

The Equilibrium Interest RateSupply and Demand in the Money MarketChanging the Money Supply to Affect the

Interest RateIncreases in Y and Shifts in the Money

Demand Curve

Looking Ahead: The Federal Reserveand Monetary Policy

Appendix A: The Various Interest Ratesin the U.S. Economy

Appendix B: The Demand for Money: A Numerical Example

CHAPTER OUTLINE

Money Demand and

the EquilibriumInterest Rate

PART III THE CORE OF MACROECONOMIC THEORY

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Interest Rates and Bond Prices

Interest The fee that borrowers pay to lenders for the use of their funds.

Professor Serebryakov Makes an EconomicError

Uncle Vanya

by Anton Chekhov

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The Demand for Money

transaction motive The main reason that people hold money—to buy things.

The Transaction Motive

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.

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Income arrives only once a month, but spending takes place continuously.

FIGURE 11.1 The Nonsynchronization of Income and Spending

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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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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.

FIGURE 11.2 Jim’s Monthly Checking Account Balances: Strategy 1

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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.

FIGURE 11.3 Jim’s Monthly Checking Account Balances: Strategy 2

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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.

FIGURE 11.4 The Demand Curve for Money Balances

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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 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 Total Demand for Money

ATMs and the Demandfor Money

Italy makes a great case study of theeffects of the spread of ATMs on thedemand for money. In Italy, virtuallyall checking accounts pay interest.What doesn’t pay interest is cash.In other words, in Italy there is an interest cost to carrying cash insteadof depositing the cash in a checking account.Orazio Attansio, Luigi Guiso, and Tullio Jappelli, “The Demand for Money, Financial Innovation and the Welfare Costs of Inflation: An Analysis with Household Data,” Journal of Political Economy, April 2002.

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The Effects of Income and the Price Level on the Demand for Money

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.

FIGURE 11.5 An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right

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The Effects of Income and the Price Level on the Demand for Money

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.)

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.

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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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Supply and Demand 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).

FIGURE 11.6 Adjustments in the Money Market

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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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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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easy monetary policy

interest

nonsynchronization of income

and spending

speculation motive

tight monetary policy

transaction motive

REVIEW TERMS AND CONCEPTS

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THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY

A P P E N D I X A

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 higher future short-term interest rates are likely to increase. These expectations will then be reflected in current long- term interest rates.

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THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY

A P P E N D I X 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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THE DEMAND FOR MONEY: A NUMERICAL EXAMPLE

A P P E N D I X B

TABLE 11B.1 Optimum Money Holdings1

Number of Switchesa

2Average Money

Holdingsb

3Average Bond

Holdingsc

4Interest Earnedd

5Cost of

Switchinge

6Net

Profitf

r = 5 percent

0 $600.00 $ 0.00 $ 0.00 $0.00 $ 0.00

1 300.00 300.00 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 16.00

Assumptions: Interest rate r = 0.05. Cost of switching from bonds to money equals $2 per transaction.

r = 3 percent

0 $600.00 $ 0.00 $ 0.00 $0.00 $ 0.00

1 300.00 300.00 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 8.00 6.40

Assumptions: Interest rate r = 0.03. 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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CHAPTER 11 Money Demand and the Equilibrium Interest Rate © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by