Money Demand, the Equilibrium Interest Rate, and Monetary Policy

1. Money Demand,the Equilibrium InterestRate, and Monetary Policy Appendix A and Appendix B Prepared by: Fernando Quijano and Yvonn Quijano

2. 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.

3. 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.

4. The Transaction Motive • There is a trade-off (مفاضلة) 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, (الاحتياط والطوارئ) • speculative.

5. The Transaction Motive • Of these the transactions motive is most important today • The transaction motive is the main reason that people hold money—to buy things.

6. 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.

7. The Nonsynchronizationof 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.

8. 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.

9. 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 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.

10. 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.

11. Appendix : The Demand forMoney: A Numerical Example

12. Appendix B: The Demand forMoney: 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.

13. The Speculation Motive • 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.

14. The Speculation Motive • Suppose the interest-bearing bond was 10% and it has increased to 12% what will occur? • When interest rates on bonds increased, the Investors will try to sell the old bonds and buy new bonds with higher interest rates. At the same time no one has a willingness to buy the old bond with the same price. The market value of old bond will decline • So, interest rates and the market value of bonds have an inverse relationship.

15. The value of bonds and interest rates interest-bearing bonds from 10% to 12% demand on the old bonds investors will try to sell the old price no one has the willingness to buy it with the same price the market value of bonds

16. The Speculation Motive • suppose I bought a bond for $1000 that offers 10% interest and hold it for a year, then decide to sell it. In the meantime, interest rates have risen and a similar bond now offers 12% a year. Could I sell my bond for $1000? No, because why would anyone buy it when he or she could spend the same amount on a new bond and earn higher interest, I would have to lower the price of the bond in order to sell it. Thus, interest rates and the market value of bonds have an inverse relationship.

17. The Speculation Motive • If someone buys a 10-year bond with a fixed rate of 10%, and a newly issued 10-year bond pays 12%, then the old bond paying 10% will have fallen in value.

18. 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.

19. Money demand and interest rates • When interest rates increased the quantity of money demand declines

20. Transactions Volumeand 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.

21. Transactions Volumeand the Price Level • When output (income) rises, the total number of transactions rises, and the demand for money curve shifts to the right.

22. Transactions Volumeand 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.

23. The Determinants ofMoney Demand: Review

24. The Determinants ofMoney 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?

25. The Equilibrium Interest Rate • The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.

26. The Equilibrium Interest Rate • 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.

27. The Equilibrium Interest Rate • At r2, households don’t have enough money to facilitate ordinary transactions. They will shift assets out of bonds and into their checking accounts.

28. Changing the MoneySupply to Affect the Interest Rate • An increase in the supply of money lowers the rate of interest.

29. Increases in Y and Shiftsin the Money Demand Curve • 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.

30. Looking Ahead: The FederalReserve 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.

31. easy monetary policy interest interest rate monetary policy nonsynchronization of income and spending speculation motive tight monetary policy transaction motive Review Terms and Concepts

32. Appendix A: The VariousInterest 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.

33. Appendix A: The VariousInterest 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

34. Appendix B: The Demand forMoney: 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.

35. Appendix B: The Demand forMoney: A Numerical Example