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PART V THE CORE OF MACROECONOMIC THEORY

The Demand for Money

Money Demand and the Equilibrium Interest Rate

CHAPTER OUTLINE
Interest Rates and Bond Prices The Demand for Money The Transaction Motive The Speculation Motive The Total Demand for Money The Effects of Income and the Price Level 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 Y and Shifts in the Money Demand Curve 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 37

For simplicity, let us assume that there are only 2 kinds of assets available to households: (1) Money: Currency in circulation and deposits in checking accounts that do not pay interest. Versus (2) Bonds: Assume to cover interest-bearing securities of all kinds. 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, versus how much you want to hold in bonds.

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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 Demand for Money (1) The Transaction Motive -the main reason that people hold moneyto buy things. Your decision to hold money involves a trade-off between: a)High liquidity of money to meet your transaction needs (transaction motive); & b)Interest income offered by bonds. The opportunity cost of holding money is the interest rate foregone on bonds. For instance, if you can earn 8% a year on bond, then holding an additional P100 in money costs you P8 a year.
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Interest The fee that borrowers pay to lenders for the use of their funds.

The Demand for Money

The Transaction Motive

The Demand for Money

The Transaction Motive

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. Illustration: Suppose that Jim earns P1200 per month. How could he manage his income optimally?

FIGURE 26.1 The Nonsynchronization of Income and Spending Income arrives only once a month, but spending takes place continuously. 5 of 37 6 of 37

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The Demand for Money

The Transaction Motive

Jim could decide to deposit his entire paycheck (P1,200) 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 P600 [(starting balance + ending balance) / 2].

FIGURE 26.2 Jims Monthly Checking Account Balances: Strategy 1 Jim could decide to deposit his entire paycheck (P1,200) 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 P600.

But he is giving up interest income from investing in bonds!

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CHAPTER 26 Money Demand and the Equilibrium Interest Rate

Jim receives P1,200 per month (30 days) and spends P40 each day. What is his average money balance? a. P40. b. P30. c. P600. d. P1,200.

The Demand for Money

The Transaction Motive

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FIGURE 26.3 Jims 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 P600 into his checking account to pay the second half of the months bills. Following this strategy, Jims average money holdings would be P300. 10 of 37

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 P600 into his checking account to pay the second half of the months bills. Following this strategy, Jims average money holdings would be P300.

The Demand for Money

The Speculation Motive 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.

Jim can continue to lower his average money holdings, but the switching from bonds to money incurs costs such as brokerage fees.
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(2) The Speculation Motive To explain the speculative motive, we need to understand the relation between bond prices and interest rates Illustration: On Jan 2, 2008, Company XYZ issued a 15-year bond that had a face value of P1000, with a coupon payment of P100 per year. Suppose that the market-determined price was P900. Interest rate = (100/900)*100 = 11.1% p.a. Suppose that the holder of the XYZ bond (Jim) wanted to sell after a year, what price could he get? It all depends on the prevailing interest rate. Let say the interest rate on Jan 2, 2009 was 20%, do you think he will be able to sell for more or less than P900?

On Jan 2, 2009, another company ABC issued a 15-year bond that had a face value of P1000. The market-determined price was P900. At the prevailing interest rate of 20%, the coupon payment was P180 p.a. As a rational investor, would you buy from: (a) Jim at P900, with a coupon payment of P100 per year (b) company ABC at P900, with a coupon payment of P180 per year Of course, a rational person would buy from company ABC! So, in order to dispose of his bond holding, Jim has to lower his selling price (say to P500). When interest rate from 11.1% to 20%, the prices of existing bonds fall (from P900 to P500). This implies a inverse relation between bond prices and interest rates.

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(2) The Speculation Motive When interest rates are high When interest rates are higher than normal, investors expect them to fall in the future (and prices of existing bonds will rise). There is a speculative motive for holding more bonds now (and hence less money), with the hope of selling them in future when bond prices rise (i.e. when interest rates fall). When interest rates are low When interest rates are lower than normal, investors expect them to rise in the future (and prices of existing bonds will fall). There is a speculative motive for holding more money now (and hence less bonds), with the hope of buying bonds in future when the prices fall (i.e. when interest rates rise). The demand for money depends negatively on interest rate (i.e. the money demand curve is downward-sloping).
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The Demand for Money

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. 16 of 37

CHAPTER 26 Money Demand and the Equilibrium Interest Rate

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.
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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 moneyfor 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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CHAPTER 26 Money Demand and the Equilibrium 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.

The Demand for Money

The Total Demand for Money

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 doesnt pay interest is cash. In other words, in Italy there is an interest cost to carrying cash instead of 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 Demand for Money

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

The Demand for Money

The Effects of Income and the Price Level on the Demand for Money 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.
TABLE 26.1 Determinants of Money Demand 1. The interest rate: interest rate.)

r (The quantity of money demanded is a negative function of the

2. The dollar volume of transactions

FIGURE 26.5 An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right 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. 21 of 37

a. Aggregate output (income): the right.) b. The price level:

Y (An increase in Y shifts the money demand curve to

P (An increase in P shifts the money demand curve to the right.)

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Other Determinants of Money Demand

The demand of money depends on the total dollar volume of transactions in the economy. Two components of total dollar volume of transactions are: a) How many transactions? b) How much is the average transaction amount? How many transactions? A reasonable indicator for the number of transactions is aggregate output (income), Y. When Y , there are more transactions in the economy, and Md shifts to the right.
CHAPTER 26 Money Demand and the Equilibrium Interest Rate

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.

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The Equilibrium Interest Rate

The Equilibrium Interest Rate

Supply and Demand in the Money Market

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.

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 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).

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CHAPTER 26 Money Demand and the Equilibrium Interest Rate

When the interest rate is above the equilibrium interest rate: a. People will move out of bonds and into moneyhold 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 26.7 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 14 percent to 7 percent.

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CHAPTER 26 Money Demand and the Equilibrium Interest Rate

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 Y and Shifts in the Money Demand Curve

FIGURE 26.8 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 7 percent to 14 percent.

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How much is the average transaction amount? The average dollar amount of each transaction depends on the prices, P. If P twice, the dollar amount of each transaction also double (twice as much money is needed to conduct the same real transaction), and Md shifts to the right. Md = P x L(Y, r) Money demand is proportional to the price level. If P doubles, Md will also double For any given P, money demand depends (through the function L) on Y and r. When Y , Md When r , Md

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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REVIEW TERMS AND CONCEPTS

CHAPTER 26 Money Demand and the Equilibrium Interest Rate

CHAPTER 26 Money Demand and the Equilibrium Interest Rate

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.

easy monetary policy interest nonsynchronization of income and spending speculation motive tight monetary policy transaction motive

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APPE ND I X A
THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY
THE TERM STRUCTURE OF INTEREST RATES
CHAPTER 26 Money Demand and the Equilibrium Interest Rate CHAPTER 26 Money Demand and the Equilibrium Interest Rate

APPE ND I X A
THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY
TYPES 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 2year rate is equal to the average of the current 1year rate and the 1-year rate expected a year from now. Peoples expectations of higher future short-term interest rates are likely to increase. These expectations will then be reflected in current longterm 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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TABLE 11B.1 Optimum Money Holdings 1 2 3 Number of Average Money Average Bond Switchesa Holdingsb Holdingsc r = 5 percent 0 1 2 3 4 P600.00 300.00 200.00 150.00* 120.00 P 0.00

4 Interest Earnedd P 0.00 15.00 20.00 22.50 24.00

5 Cost of Switchinge P0.00 2.00 4.00 6.00 8.00

6 Net Profitf P 0.00 13.00 16.00 16.50 16.00

Number of switches: 0 = Jim puts all the P1200 into his checking account. 1 = Jim buys one bond, indicating he puts P600 into his checking account, and uses the remaining P600 to buy bond. 2 = Jim buys two bonds, indicating that he puts P400 into his checking account, and buys two P400 bonds. 3 = Jim buys three bonds, indicating that he puts P300 into his checking account, and buys 3 P300 bonds. 4 = Jim buys four bonds, indicating that he puts P240 into his checking account, and buys 4 P240 bonds. Average Money Holdings (AMH): AMH = (starting balance + ending balance) / 2 When switches When switches When switches When switches When switches = 0, AMH = 1, AMH = 2, AMH = 3, AMH = 4, AMH = (1200 + 0) / 2 = P600 = (600 + 0) / 2 = P300 = (400 + 0) / 2 = P200 = (300 + 0) / 2 = P150 = (240 + 0) / 2 = P120
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300.00 400.00 450.00 480.00 r = 3 percent

Assumptions: Interest rate r = 0.05. Cost of switching from bonds to money equals P2 per transaction.

0 1 2 3 4

P600.00 300.00 200.00* 150.00 120.00

P 0.00 300.00 400.00 450.00 480.00

P 0.00 9.00 12.00 13.50 14.40

P0.00 2.00 4.00 6.00 8.00

P 0.00 7.00 8.00 7.50 6.40

c

Assumptions: Interest rate r = 0.03. Cost of switching from bonds to money equals P2 per transaction. *Optimum money holdings. a That is, the number of times you sell a bond. b Calculated as 600/(col. 1 + 1). 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 (P2). Calculated as col. 4 col. 5

Average Bond Holdings (ABH): ABH = (starting balance + ending balance) / 2 When switches When switches When switches When switches When switches Summary: When r = 5%, optimal money holdings = P150 When r = 3%, optimal money holdings = P200 The lower the rate, the more money on average is held. The higher the rate, the higher the opportunity cost (more interest foregone) from holding money, the less money on average is held. The demand for money depends negatively on interest rate (i.e. the money demand curve is downward-sloping). = 0, ABH = 1, ABH = 2, ABH = 3, ABH = 4, ABH = (0 + 0) / 2 = P0 = (600 + 0) / 2 = P300 = (800 + 0) / 2 = P400 = (900 + 0) / 2 = P450 = (960 + 0) / 2 = P480