Money Demand the Equilibrium Interest Rate 26 CHAPTER

Money Demand the Equilibrium Interest Rate 26 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 PART V The Core of Macroeconomic Theory The Equilibrium Interest Rate © 2012 Pearson Education 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 1 of 25

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. PART V The Core of Macroeconomic Theory When interest rates rise, the prices of existing bonds fall. © 2012 Pearson Education 2 of 25

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. PART V The Core of Macroeconomic Theory The Transaction Motive transaction motive The main reason that people hold money—to buy things. 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. © 2012 Pearson Education 3 of 25

The Demand for Money PART V The Core of Macroeconomic Theory The Transaction Motive © 2012 Pearson Education FIGURE 26. 1 The Nonsynchronization of Income and Spending Income arrives only once a month, but spending takes place continuously. 4 of 25

The Demand for Money PART V The Core of Macroeconomic Theory The Transaction Motive FIGURE 26. 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. © 2012 Pearson Education 5 of 25

The Demand for Money FIGURE 26. 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. PART V The Core of Macroeconomic Theory The Transaction Motive © 2012 Pearson Education 6 of 25

The Demand for Money PART V The Core of Macroeconomic Theory The Transaction Motive FIGURE 26. 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. © 2012 Pearson Education 7 of 25

The Demand for Money The Speculation Motive PART V The Core of Macroeconomic Theory speculation motive One reason for holding bonds instead of money: Because the market price of interestbearing 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. © 2012 Pearson Education 8 of 25

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. PART V The Core of Macroeconomic Theory 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. © 2012 Pearson Education 9 of 25

The Demand for Money PART V The Core of Macroeconomic Theory The Effect of Nominal Income on the Demand for Money © 2012 Pearson Education FIGURE 26. 5 An Increase in Nominal Aggregate Output (Income) (P • Y) Shifts the Money Demand Curve to the Right 10 of 25

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. TABLE 26. 1 Determinants of Money Demand 1. The interest rate: r (The quantity of money demanded is a negative function of the interest rate. ) PART V The Core of Macroeconomic Theory 2. Aggregate nominal output (income) P • Y © 2012 Pearson Education a. Real aggregate output (income): Y (An increase in Y shifts the money demand curve to the right. ) b. The aggregate price level: P (An increase in P shifts the money demand curve to the right. ) 11 of 25

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? PART V The Core of Macroeconomic Theory The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy. © 2012 Pearson Education 12 of 25

The Equilibrium Interest Rate Supply and Demand in the Money Market PART V The Core of Macroeconomic Theory FIGURE 26. 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 r 0 the price of bonds would be bid up (and thus the interest rate down). At r 1 the price of bonds would be bid down (and thus the interest rate up). © 2012 Pearson Education 13 of 25

The Equilibrium Interest Rate Changing the Money Supply to Affect the Interest Rate FIGURE 26. 7 The Effect of an Increase in the Supply of Money on the Interest Rate PART V The Core of Macroeconomic Theory An increase in the supply of money from MS 0 to MS 1 lowers the rate of interest from 7 percent to 4 percent. © 2012 Pearson Education 14 of 25

The Equilibrium Interest Rate Increases in P • Y and Shifts in the Money Demand Curve FIGURE 26. 8 The Effect of an Increase in Nominal Income (P • Y) on the Interest Rate PART V The Core of Macroeconomic Theory An increase in nominal income (P • Y) shifts the money demand curve from Md 0 to Md 1, which raises the equilibrium interest rate from 4 percent to 7 percent. © 2012 Pearson Education 15 of 25

Looking Ahead: The Central Bank and Monetary Policy tight monetary policy CB policies that contract the money supply and thus raise interest rates in an effort to restrain the economy. PART V The Core of Macroeconomic Theory easy monetary policy CB policies that expand the money supply and thus lower interest rates in an effort to stimulate the economy. © 2012 Pearson Education 16 of 25

REVIEW TERMS AND CONCEPTS easy monetary policy interest nonsynchronization of income and spending PART V The Core of Macroeconomic Theory speculation motive © 2012 Pearson Education tight monetary policy transaction motive 17 of 25

CHAPTER 26 APPENDIX B The Demand For Money: A Numerical Example TABLE 26 B. 1 Optimum Money Holdings PART V The Core of Macroeconomic Theory 1 Number of Switchesa 2 Average Money Holdingsb 0 $600. 00 1 3 Average Bond Holdingsc r 5 percent $ 4 Interest Earnedd 5 Cost of Switchinge 6 Net Profitf 0. 00 $0. 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 1 $ 0. 00 $0. 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. a. That is, the number of times you sell a bond. b. Calculated as 600/(col. 1 1). c. Calculated as 600 col. 2. d. Calculated as r col. 3, where r is the interest rate. e. Calculated as t col. 1, where t is the cost per switch ($2). f. Calculated as col. 4 col. 5. © 2012 Pearson Education 18 of 25