CHAPTER 23 Money Demand the Equilibrium Interest Rate

CHAPTER 23 Money Demand, the Equilibrium Interest Rate, and Monetary Policy 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 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy and Interest • Monetary policy is the behavior of the Central Bank 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2

C H A P T E R 23: 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: • 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 interestbearing securities, such as bonds. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3

C H A P T E R 23: 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. • The transaction motive is the main reason that people hold money—to buy things. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 4

C H A P T E R 23: 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 5

C H A P T E R 23: 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 6

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy Money Management • Selim 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 7

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy Money Management • Selim 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 8

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy The Optimal Balance • There is a level of average money holdings that earns Selim the most profit, taking into account both the interest earned on bonds and the cost paid for switching from bonds to money. This level is his optimal balance. • An increase in the interest rate lowers the optimal money balance. People want to take advantage of the high return on bonds, so they choose to hold very little money. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 9

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy The Speculation Motive © 2004 Prentice Hall Business Publishing • 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. Principles of Economics, 7/e Karl Case, Ray Fair 10

C H A P T E R 23: 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 10 year 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. • When interest rates are high (low) and expected to fall (rise), demand for bonds is likely to be high (low) thus money demand is likely to be low (high). © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11

C H A P T E R 23: 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 12

C H A P T E R 23: 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 13

C H A P T E R 23: 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 value of transactions made. • The total dollar volume of transactions, in turn, depends on aggregate income and overall price level. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 14

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy Transactions Volume and the Price Level © 2004 Prentice Hall Business Publishing • When output (income) rises, the total number of transactions rises, and the demand for money curve shifts to the right. Principles of Economics, 7/e Karl Case, Ray Fair 15

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy Transactions Volume and the Price Level • When the price level rises, the quantity of money needed to engage in transactions rises, and the demand for money curve shifts to the right. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 16

C H A P T E R 23: 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) • Money demand is a stock variable, measured at a given point in time. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 17

C H A P T E R 23: 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? © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 18

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy The Equilibrium Interest Rate © 2004 Prentice Hall Business Publishing • The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy. Principles of Economics, 7/e Karl Case, Ray Fair 19

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy The Equilibrium Interest Rate © 2004 Prentice Hall Business Publishing • At r 1, the amount of money in circulation is higher than households and firms wish to hold. Interest rates must fall to encourage people to hold more money and fewer bonds. Principles of Economics, 7/e Karl Case, Ray Fair 20

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy The Equilibrium Interest Rate © 2004 Prentice Hall Business Publishing • At r 2, households don’t have enough money to facilitate ordinary transactions. People wil sell bonds in order to increase their money holdings. This drives down bond prices and causes interest rates to rise. Principles of Economics, 7/e Karl Case, Ray Fair 21

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy Changing the Money Supply to Affect the Interest Rate © 2004 Prentice Hall Business Publishing • An increase in the supply of money lowers the rate of interest. Principles of Economics, 7/e Karl Case, Ray Fair 22

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy Increases in Y and Shifts in the Money Demand Curve © 2004 Prentice Hall Business Publishing • 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. Principles of Economics, 7/e Karl Case, Ray Fair 23

C H A P T E R 23: Money Demand, the Equilibrium Interest Rate, and Monetary Policy Looking Ahead: Central Bank and Monetary Policy • Tight monetary policy refers to the CB policies that contract the money supply in an effort to restrain the economy. • Easy monetary policy refers to the CB policies that expand the money supply in an effort to stimulate the economy. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 24