The Demand for Money
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.
A household or business only wants to hold a fraction of its financial wealth as money.
How about demands for income and wealth? (very large or infinite)
-­‐ Money earns zero interest, bonds earn positive nominal interest. Since we have already learned about money, let’s start with bonds.
Interest Rates and Bond Prices
Interest The fee that borrowers pay to lenders for the use of their funds. Fundamentally a bond is a promise to make one or more future payments on specific dates.
Interest Rates and Bond Prices
Price of bonds are determined in the bonds market. (The price of bond initially sells for is roughly equal to face value)
The interest rate is the annual interest payment on a loan expressed as a percentage of the amount of the loan (for bond, dividing the coupon by the price of bond).
r(yield) =[coupon/price of bond] * 100% *Clearly, interest rates and the market determined price of bonds are negatively(inversely) related. At the higher interest rate, if you want to sell your bond out, you have to lower the price of your bond. A decrease in a bond’s price always means the interest rate on the bond (the yield to maturity) has risen.
In reality, different types of bonds have different interest rates in the market.
For our analysis, we assume that there is only one type of bond and the only one interest rate on that bond.
The Demand for Money
The Transaction Motive transaction motive The main reason that people hold money—to buy things.
Suppose your income is 100,000 baht per month. You will not hold all your income in your wallet everyday, perhaps you put your money in the bank as demand deposit (checking account). Your transaction demand for money will be only a part of your total income.
Instead of holding all your income at checking account (assuming that checking account does not earn interest), you can make profit using these money.
Let’s have a look on how people manage their income in holding assets. The Demand for Money
The Transaction Motive
The Nonsynchronization of Income and Spending
Income arrives only once a month, but spending takes place continuously. No one spends all his income on one day, so income and spending are not matched.
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.
The Demand for Money
The Transaction Motive
Jim’s Monthly Checking Account Balances: Strategy 1
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 {Average holding of money = [starting balance(1200) + ending balance(0)] / 2}. Jim is doing nothing using his money, just spending all income in one month.
The Demand for Money
The Transaction Motive
Jim’s Monthly Checking Account Balances: Strategy 2
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. He could not only spend the same money for the whole month but also earn some interest earning. 9
The Demand for Money
The Transaction Motive
Strategy 3
Jim could also choose to put 1/3 ($400) of his paycheck into his checking account and buy two bonds with the other 2/3 (2 *$400= $800) of his income.
At 10th day of month, Jim would sell one bond and deposit the $400 into his checking account to pay the second 10 days of the month’s bills.
At 20ty day of month, Jim would sell the last bond and deposit the $400 into his checking account to pay the last 10 days of the month’s bills.
Following this strategy, Jim’s average money holdings would be only $200.
He could not only spend the same money for the whole month but also earn some interest earning which would be higher than strategy 2’s.
The Demand for Money
The Transaction Motive
We observe that the more bonds he holds, the more interest earning he gets and the less average money he will hold.
If this person wants to maximize his interest earning, he will hold bonds using almost all his monthly income by leaving very small amount of money for instance use.
If so, his average money holding will be very small. In reality, money management of this kind is costly (holding bonds also has cost). The Demand for Money
The Transaction Motive
The following are the benefits and costs of holding money and investing money on bonds. Benefits of holding money = money is useful for transactions(buying things).
Costs of holding money = no interest earning in checking account (give up the opportunity to earn interest)
Benefits of holding bonds = gain interest earning
Costs of holding bonds = time and fees for switching bonds to money when needed.
Considering both benefits and costs of holding bonds, we find an optimal balance of holding money at which we get highest benefits from both holding bonds and money.
The optimal balance is the level of average money balance that earns the consumer the most net profit, taking into account both the interest earned on bonds and the costs paid for switching from bonds to money.
The Demand for Money
The Transaction Motive
At the optimal balance of holding money, if interest rate rises, our opportunity to make interest profit from that money will also be higher. If we are still holding money, we are giving up this opportunity, so that our opportunity cost will be higher.
So interest rate can be said as our opportunity cost of holding money.
Higher interest rate → higher opportunity cost → lower balance of holding money
(demand for money)
In other words, at the higher interest rate, bonds are more attractive than money, thus demand for money lowers.
Accordingly, money demand depends on interest rate inversely (negatively). When interest rates are high, people tend to hold very little money, Md will fall.
The Demand for Money
The Transaction Motive
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.
The Demand for Money
The Speculation Motive
Speculators are making profit by buying and selling bonds. speculation motive One reason for holding bonds instead of money:
Because the market price of interest-­‐bearing 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.
Higher interest rate → lower bond prices → higher demand for bonds → lower demand for money
Although their reason for holding bonds is different from reasons of ordinary people and business firms, it has the same impacts on demand for money.
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.
Md = cash + checking account balances
Although households and firms need to hold balances for everyday transactions, their demand has a limit. Total money demand will always be less than income.
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.
So, total demand for money curve is also downward sloping.
The Effect of Nominal Income on the Demand for Money
An Increase in Nominal Aggregate Output
(Income) (P •Y) Shifts 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.
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 11.1 Determinants of Money Demand
1. The interest rate: r (The quantity of money
demanded is a negative function of the
interest rate.)
2. Aggregate nominal output (income)P•Y 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.)
We can see the movement along the demand curve only when interest rate changes.
Other factors that affect demand for money will cause a shift of Md curve.
Technological improvements such as internet banking and ATM lower the cost of transferring funds and may reduce the demand for money.
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?
The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.
If the money demand is greater than the money supply, the interest rate rises. If money demand is less than the money supply, the interest rate falls.
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The Equilibrium Interest Rate
Supply and Demand in the Money Market
FIGURE 11.6 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 higher interest rate,r0, bonds are attractive; demand for bonds increases; bonds prices are raised gradually; consequently, interest rate will go down.
At lower interest rate, r1, bonds are not attractive; selling more and more bonds; bonds prices are declined gradually; then interest rate will go up.
The Equilibrium Interest Rate
Changing the Money Supply to Affect the Interest Rate
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 7 percent to 4 percent. If money supply is decreased, interest rate will be higher.
Using three instruments; changing RRR, changing discount rate, and buying or selling government securities in the open market: The Fed can raise the interest rate by decreasing the money supply and can lower the interest rate by increasing the money supply.
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Increases in P • Y and Shifts in the Money Demand Curve
The Effect of an Increase in Nominal Income
(P • Y) on the Interest Rate
An increase in nominal income (P • Y) shifts the
money demand curve from Md0 to Md1, which
raises the equilibrium interest rate from 4
percent to 7 percent.
The same impact will be occurred when there is an increase in price levels (P).
The opposite effect will happen if there is a decrease in aggregate income (Y) or a decrease in price levels (P). Md will shift to the left and r will decline.
Zero Interest Rate Bound
By the middle of 2008 the Fed had driven the
short-term interest rate close to zero, and it
remained at essentially zero through the time of
this writing (March 2013).
The Fed does this, of course, by increasing the
money supply until the intersection of the money
supply at the demand for money curve is at an
interest rate of roughly zero.
The Fed cannot drive the interest rate lower than
zero, preventing it from stimulating the economy
further.