Chapter 20: Monetary Policy
The Demand for Money
• Disadvantage of holding money?
– Opportunity Cost
• Motives for holding money?
– Keynes gave three…
Money Demand
• Transactions demand for money: money people
hold to pay everyday expenses.
– “walking around money”
• Precautionary demand for money: money people
hold to pay unpredictable expenses.
– “rainy day money”
• These tend to depend on variables that aren’t in
our model.
Money Demand
• Speculative demand for money: money
people hold to take advantage of expected
changes in non-money financial assets.
– Also, think of this as the demand for money as an
asset.
– If the interest rate increases, should I increase or
decrease my speculative demand for money?
Money Demand
• If the interest rate increases, should I increase
or decrease my speculative demand for
money?
• Decrease because the opportunity cost has
increased – money is “more expensive.”
• Example: checking account vs. bonds
• There is an inverse relationship between the
demand for money and the interest rate.
•Downward-sloping
due to speculative
demand.
•Equilibrium interest
rate.
Bond prices and interest rates
• The interest rate (annual yield) on a bond
depends on its market price and its annual
interest payment.
• Example: Suppose a 20-year government bond
pays $50 annually and is currently selling for
$1000. Then,
interest rate = $50/$1000 = 5%
Bond prices and interest rates
• Now, suppose that an decrease in the demand
for bonds drops the price of the bond to $500.
interest rate = $50/$500 = 10%
• When the bond price fell, the interest rate
rose.
• There is an inverse relationship between bond
prices and interest rates.
Interest rates and Investment Demand