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MacroLecture8Money demand, the equilibrium

interest rate, and monetary policyTo understand central banks short-run

influence on the interest rate, we must

understand what determines thedemand for money, the supply ofmoney, and the forces that bringequilibrium in the money market.

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The demand for money

The amount of money that householdsand firms choose to hold is the

quantity of money demanded.What determines the quantity of money

demanded?

It depends on a benefit-opportunity costcalculation.

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Benefit of holding money

Money is the means of payment and that itserves as a medium of exchange, unit ofaccount, and store of value.

You dont need any money to use it as a unit

of account. You dont need any money to

store your wealthyou can store it in theform of bonds, stocks.

The more money you hold, the easier it is foryou to make payment and transactions.

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Opportunity cost of holdingmoney

The opportunity cost of holding moneyis the interest foregone on analternative assets.

e.g. If you can earn 8% a year, thenholding an additional $100 in moneycosts you $8 a year.

Your opportunity cost of holding $100 inmoney is the goods and servicesworth $8 that you must forgo.

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Three motives for holdingmoney

Transaction demand for money

Individuals hold money for use intransactions. The amount of money held fortransactions would vary positively with thevolume of transactions.

Income is a good measure of this volume of

transactions

the transaction demand formoney is assumed to depend positively onthe level of income.

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Contd.

Precautionary demand for money

Apart from money held for planned

transactions, additional moneybalances were held in case ofunexpected expenditures such asmedical or repair bills.

The amount held for this purposedepends positively on income.

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Contd.

Speculative demand for money

Because of the uncertainty about futureinterest rates and the relationship betweenchanges in the interest rate and the price ofbondsadditional demand for money willexist.

The opportunity cost of holding money isthe interest rate foregone on an alternativeassets (e.g. bonds)

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Contd.

If you can earn 8% a year on a mutual fundaccount. Holding an additional $100 inmoney costs you $8 a year.

Your opportunity cost of holding $100 inmoney is the goods and services worth $8that you must forego.

The opportunity cost of holding money =

nominal interest ratenominal interest rate = real interest rate +inflation rate

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The demand for moneycurve

The demand for money (Md) is therelationship between the quantity of

money demanded and the nominalinterest rate, when all other influenceson the amount of money that peoplewish to hold remain the same.

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Contd.

Md

Qty of money

Nominalinterest

rate (i)

A rise inthe interest

rate

A fall in theinterest rate

When the interest rate

rises (other factors

remaining the same),

the opportunity costof holding money

rises qty. of money

demanded decreases.

When the interest rate

falls (other factors

remaining the same),the opportunity cost

of holding money ,

qty of money

demanded

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Changes in the Md

A change in any other influence onmoney holding changes Md.

3 main influences on Md(i) The price level

(ii) Real GDP (income)

(iii) Financial technology

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Contd.

(i) The price level

Md is proportional to the price level. This is because wehold money to make payments.

If P Md curve shifts rightward

If P Md curve shifts leftward

(ii) Real GDP

Md increases as real GDP increases. Expenditures and

incomes increase when real GDP increases.If Y Md curve shifts rightward

If Y Md curve shifts leftward

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Contd.

(iii) Financial technologyChanges in financial technology change Md.Daily interest checking deposits and automatic transfers

between checking and saving deposits enable people

to earn interest on money Lower the opportunity cost of holding money Increase Md

Automatic Teller Machine (ATM), debit cards Have made money easier to obtain and use.

Have increased Md (i.e. Md curve shifts to the right)Credit cards have made it easier for people to buy goods

and services on creditThis has decreased Md (Md curve shifts leftward)

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Money market equilibrium

The quantity of money supplied (Ms) isdetermined by the actions of the

banking system and the central bank.The supply of moneythe relationship

between the quantity of moneysupplied and the nominal interest.

Equilibrium in the money market occurswhen Md = Ms.

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Contd.

Ms

Md

Nominalinterest rate

ie

i1

i2

Excess Ms. Peoplebuy bonds & the

interest rate

Excess Md.People sellbonds & the

interest rate

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Changing the interest rate

Mso

Md

Nominalinterest rate

io

i1

i2

Ms1Ms2

Qty of money

To change the interest

rate, CB changes the

qty of money.

CB qty of money, Mscurve shifts right from

Mso to Ms1, interest

rate from io to i1.

CB qty of money, Ms

curve shifts left from

Mso to Ms2, interestrate from io to i2.