© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 22 Prepared...

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

Money Demand, the Money Demand, the Equilibrium Interest Rate, and Equilibrium Interest Rate, and

Monetary PolicyMonetary Policy


The Demand for MoneyThe Demand for Money

• The main concern in the study of the The main concern in the study of the demand for money is:demand for money is:

• How much of your financial assets you How much of your financial assets you want to hold in the form of money, which want to hold in the form of money, which does not earn interest, versus how much does not earn interest, versus how much you want to hold in interest-bearing you want to hold in interest-bearing securities.securities.


The Transactions MotiveThe Transactions Motive

• There is a trade-off between the liquidity of There is a trade-off between the liquidity of money and the interest income offered by money and the interest income offered by other kinds of assets.other kinds of assets.

• The The transactions motivetransactions motive is the main is the main reason that people hold money—to buy reason that people hold money—to buy things.things.


The Transactions MotiveThe Transactions Motive

Simplifying assumptions in the study of the Simplifying assumptions in the study of the demand for money:demand for money:

• There are only two kinds of assets available to There are only two kinds of assets available to households: bonds and money.households: bonds and money.

• The typical household’s income arrives once a The typical household’s income arrives once a month, at the beginning of the month.month, at the beginning of the month.

• Spending occurs at a completely uniform rate—Spending occurs at a completely uniform rate—the same amount is spent each day.the same amount is spent each day.

• Spending is exactly equal to income for the Spending is exactly equal to income for the month.month.


The Nonsynchronization ofThe Nonsynchronization ofIncome and SpendingIncome and Spending

• The mismatch between the The mismatch between the timing of money inflow and timing of money inflow and the timing of money outflow the timing of money outflow is called the is called the nonsynchronization of nonsynchronization of income and spending.income and spending.

• Income arrives only once a month, but Income arrives only once a month, but spending takes place continuously.spending takes place continuously.


Money ManagementMoney Management

• Jim could decide to Jim could decide to deposit his entire deposit his entire paycheck ($1,200) into his paycheck ($1,200) into his checking account at the checking account at the start of the month and run start of the month and run his balance down to zero his balance down to zero by the end of the month.by the end of the month.

• In this case, his average In this case, his average money holdings would be money holdings would be $600.$600.


Money ManagementMoney Management

• Jim could decide to Jim could decide to deposit half of his deposit half of his paycheck ($1,200) into his paycheck ($1,200) into his checking account, and buy checking account, and buy a $600 bond with the other a $600 bond with the other half. At mid-month, he half. At mid-month, he could sell the bond and could sell the bond and deposit the $600 into his deposit the $600 into his checking account.checking account.

• Month over month, his Month over month, his average money holdings average money holdings would be $300.would be $300.


The Optimal BalanceThe Optimal Balance

• There is a level of average money holdings There is a level of average money holdings that earns Jim the most profit, taking into that earns Jim the most profit, taking into account both the interest earned on bonds account both the interest earned on bonds and the cost paid for switching from bonds and the cost paid for switching from bonds to money. This level is his to money. This level is his optimal balanceoptimal balance..

• An increase in the interest rate lowers the An increase in the interest rate lowers the optimal money balance. People want to optimal money balance. People want to take advantage of the high return on bonds, take advantage of the high return on bonds, so they choose to hold very little money.so they choose to hold very little money.


The Speculation MotiveThe Speculation Motive

• The The speculation motivespeculation motive is is one reason for holding one reason for holding bonds instead of money: bonds instead of money: Because the market value Because the market value of interest-bearing bonds is of interest-bearing bonds is inversely related to the inversely related to the interest rate, investors may interest rate, investors may wish to hold bonds when wish to hold bonds when interest rates are high with interest rates are high with the hope of selling them the hope of selling them when interest rates fall.when interest rates fall.


The Speculation MotiveThe Speculation Motive

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

• Higher bond prices mean that the interest a Higher bond prices mean that the interest a buyer is willing to accept is lower than before.buyer is willing to accept is lower than before.

• When interest rates are high (low) and When interest rates are high (low) and expected to fall (rise), demand for bonds is expected to fall (rise), demand for bonds is likely to be high (low) and money demand is likely to be high (low) and money demand is likely to be low (high).likely to be low (high).


The Total Demand for MoneyThe Total Demand for Money

• The total quantity of money demanded in the The total quantity of money demanded in the economy is the sum of the demand for economy is the sum of the demand for checking account balances and cash by both checking account balances and cash by both households and firms.households and firms.

• The quantity of money demanded at any The quantity of money demanded at any moment depends on the opportunity cost of moment depends on the opportunity cost of holding money, a cost determined by the holding money, a cost determined by the interest rate. A higher interest rate raises the interest rate. A higher interest rate raises the opportunity cost of holding money and thus opportunity cost of holding money and thus reduces the demand for money.reduces the demand for money.


The Determinants of Money DemandThe Determinants of Money Demand

• The total demand for money in the The total demand for money in the economy depends on the total dollar economy depends on the total dollar volume of transactions made.volume of transactions made.

• The total dollar volume of transactions, in The total dollar volume of transactions, in turn, depends on the turn, depends on the totaltotal number of number of transactions, and the transactions, and the averageaverage transaction transaction amount.amount.


Transactions Volume andTransactions Volume andthe Level of Outputthe Level of Output

• When output (income) When output (income) rises, the rises, the totaltotal number number of transactions rises, of transactions rises, and the demand for and the demand for money curve shifts to money curve shifts to the right.the right.


Transactions Volume andTransactions Volume andthe Price Levelthe Price Level

• When the price level When the price level rises, the rises, the averageaverage dollar amount of each dollar amount of each transaction rises; thus, transaction rises; thus, the quantity of money the quantity of money needed to engage in needed to engage in transactions rises, and transactions rises, and the demand for money the demand for money curve shifts to the right.curve shifts to the right.


The Determinants of Money DemandThe Determinants of Money Demand

• Money demand is not a flow measure. Money demand is not a flow measure. Rather it is a Rather it is a stock variablestock variable, measured at a , measured at a given point in time.given point in time.

• Money demand answers the question:Money demand answers the question:• How much money do firms and households How much money do firms and households

desire to hold at a specific point in time, given the desire to hold at a specific point in time, given the current interest rate, volume of economic activity, current interest rate, volume of economic activity, and price level?and price level?

• How much of its assets a household holds in How much of its assets a household holds in the form of money is different from how the form of money is different from how much of its income it spends during the year.much of its income it spends during the year.


The Equilibrium Interest RateThe Equilibrium Interest Rate

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



• At At rr11, amount of money , amount of money in circulation is higher in circulation is higher than households and than households and firms want to hold. firms want to hold. They will attempt to They will attempt to reduce their money reduce their money holdings by buying holdings by buying bonds.bonds.



• At At rr22, households don’t , households don’t have enough money to have enough money to facilitate ordinary facilitate ordinary transactions. They will transactions. They will shift assets out of shift assets out of bonds and into their bonds and into their checking accounts.checking accounts.


Changing the Money SupplyChanging the Money Supplyto Affect the Interest Rateto Affect the Interest Rate

• An increase in the supply An increase in the supply of money lowers the rate of money lowers the rate of interest.of interest.

• To expand the money To expand the money supply the fed can reduce supply the fed can reduce the reserve requirement, the reserve requirement, cut the discount rate, or cut the discount rate, or buy U.S. government buy U.S. government securities in the open securities in the open market.market.


Increases in Increases in YY and Shifts in and Shifts inthe Money Demand Curvethe Money Demand Curve

• An increase in aggregate An increase in aggregate output (income) shifts the output (income) shifts the money demand curve, money demand curve, which raises the which raises the equilibrium interest rate equilibrium interest rate from 7 percent to 14 from 7 percent to 14 percent.percent.

• An increase in the price An increase in the price level has the same effect.level has the same effect.


The Federal Reserve andThe Federal Reserve andMonetary PolicyMonetary Policy

• Tight monetary policyTight monetary policy refers to Fed refers to Fed policies that contract the money policies that contract the money supply in an effort to restrain the supply in an effort to restrain the economy.economy.

• Easy monetary policyEasy monetary policy refers to Fed refers to Fed policies that expand the money policies that expand the money supply in an effort to stimulate the supply in an effort to stimulate the economy.economy.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 22 Prepared...

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Transcript of © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 22 Prepared...