Money Demand and the Equilibrium Interest Rate

P R I N C I P L E S O F MACROECONOMICS T E N T H E D I T I O N CASE FAIR OSTER Prepared by: Fernando Quijano & Shelly Tefft

Money Demand and the Equilibrium Interest Rate 11 CHAPTER OUTLINE Interest Rates and Bond Prices The Demand for Money The Transaction Motive The Speculation Motive The Total Demand for Money The Effect of Nominal Income 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 P • Y and Shifts in the Money Demand Curve Zero Interest Rate Bound 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

Interest Rates and Bond Prices interest The fee that borrowers pay to lenders for the use of their funds. Firms and governments borrow funds by issuing bonds, and they pay interest to the lenders that purchase the bonds. When interest rates rise, the prices of existing bonds fall.

E C O N O M I C S I N P R A C T I C E Professor Serebryakov Makes an Economic Error In Chekhov’s play Uncle Vanya, Alexander Vladimirovitch Serebryakov, a retired professor, but apparently not of economics, calls his household together to propose the following: …Our estate yields on an average not more than two per cent, on its capital value. I propose to sell it. If we invest the money in suitable securities, we should get from four to five per cent, and I think we might even have a few thousand roubles to spare… Uncle Vanya tried to kill Professor Serebryakov for this idea, but no one pointed out that this was bad economics and not a scheme. Perhaps had Uncle Vanya taken an introductory economics course and known this, he would have been less agitated.

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 motiveThe main reason that people hold money—to buy things. nonsynchronization of income and spendingThe mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses.

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.

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.

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.

The Demand for Money  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. The Transaction Motive

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.

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.

The Demand for Money The Speculation Motive speculation motiveOne 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.

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.

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.

E C O N O M I C S I N P R A C T I C E ATMs and the Demand for Money Italy makes a great case study of the effects of the spread of ATMs on the demand for money. In Italy, virtually all checking accounts pay interest. What doesn’t pay interest is cash. The study found that the demand for cash responds to changes in the interest rate paid on checking accounts. The higher the interest rate, the less cash held. In other words, when the interest rate on checking accounts rises, people go to ATM machines more often and take out less in cash each time, thereby keeping, on average, more in checking accounts earning the higher interest rate.

The Demand for Money The Effect of Nominal Income on the Demand for Money  FIGURE 11.5 An Increase in Nominal Aggregate Output (Income) (P •Y) Shifts the Money Demand Curve to the Right

The Demand for Money The Effect of Nominal Income on the Demand for Money The demand for money depends negatively on the interest rate, r, and positively on real income, Y, and the price level, P.

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.

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.

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). At r1 the price of bonds would be bid down (and thus the interest rate up).

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.

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 MS0 to MS1 lowers the rate of interest from 7 percent to 4 percent.

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.

The Equilibrium Interest Rate Increases in P • Y and Shifts in the Money Demand Curve  FIGURE 11.8 The Effect of an Increase in Nominal Income (P • Y) on the Interest Rate An increase in nominal income (P • Y) shifts the money demand curve from Md0 to Md1, which raises the equilibrium interest rate from 4 percent to 7 percent.

The Equilibrium Interest Rate Zero Interest Rate Bound By the middle of 2008 the Fed had driven the short-term interest rate close to zero, and it remained at essentially zero through the middle of 2010. The Fed does this, of course, by increasing the money supply until the intersection of the money supply at the demand for money curve is at an interest rate of roughly zero. The Fed cannot drive the interest rate lower than zero, preventing it from stimulating the economy further.

Looking Ahead: The Federal Reserve and Monetary Policy tight monetary policyFed policies that contract the money supply and thus raise interest rates in an effort to restrain the economy. easy monetary policyFed policies that expand the money supply and thus lower interest rates in an effort to stimulate the economy.

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.

R E V I E W T E R M S A N D C O N C E P T S easy monetary policy interest nonsynchronization of income and spending speculation motive tight monetary policy transaction motive

The termstructure of interest rates is the relationship among the interest rates offered on securities of different maturities. CHAPTER 11 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. Fed behavior may directly affect people’s expectations of the future short-term rates, which will then affect long-term rates.

Three-Month Treasury Bill RateProbably the most widely followed short-term interest rate. Government Bond RateThere are 1-year bonds, 2-year bonds, and so on, up to 30-year bonds. Bonds of different terms have different interest rates. Federal Funds RateThe rate banks are charged to borrow reserves from other banks. Generally a 1-day rate on which the Fed has the most effect through its open market operations. Commercial Paper RateShort-term corporate IOUs that offer a designated rate of interest depending on the financial condition of the firm and the maturity date of the IOU. Prime RateA benchmark that banks often use in quoting interest rates to their customers depending on the cost of funds to the bank; it moves up and down with changes in the economy. AAA Corporate Bond RateClassified by various bond dealers according to their risk. Bonds have a longer maturity than commercial paper. The interest rate on bonds rated AAA is the triple A corporate bond rate, the rate that the least risky firms pay on the bonds that they issue. CHAPTER 11 APPENDIX A The Various Interest Rates in the U.S. Economy Types of Interest Rates

CHAPTER 11 APPENDIX B The Demand For Money: A Numerical Example

Money Demand and the Equilibrium Interest Rate