CHAPTER
11
Money Demand,
the Equilibrium Interest
Rate, and Monetary Policy
Appendix A and Appendix B
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Monetary Policy and Interest
• Monetary policy is the behavior of the
Federal Reserve concerning the money
supply.
• Interest is the fee that borrowers pay to
lenders for the use of their funds.
• Interest rate is the annual interest
payment on a loan expressed as a
percentage of the loan.
interest received per year
Interest rate 
x100
amount of the loan
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Karl Case, Ray Fair
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Demand for Money
• The main concern in the study of the
demand for money is:
• 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 interestbearing securities, such as bonds.
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Karl Case, Ray Fair
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
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.
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Karl Case, Ray Fair
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Total Demand for Money
• The quantity of money demanded at
any moment depends on the
opportunity cost of holding money, a
cost determined by the interest rate.
• A higher interest rate raises the
opportunity cost of holding money and
thus reduces the quantity of money
demanded.
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Karl Case, Ray Fair
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Transactions Volume
and the Price Level
• The total demand for money in the
economy depends on the total dollar
volume of transactions made.
• The total dollar volume of
transactions, in turn, depends on the
total number of transactions, and the
average transaction amount.
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Karl Case, Ray Fair
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Transactions Volume
and the Price Level
© 2004 Prentice Hall Business Publishing
• When output
(income) rises, the
total number of
transactions rises,
and the demand for
money curve shifts
to the right.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Transactions Volume
and the Price Level
• When the price level rises, the
average dollar amount of each
transaction rises; thus, the quantity
of money needed to engage in
transactions rises, and the demand
for money curve shifts to the right.
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Karl Case, Ray Fair
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Determinants of
Money Demand: Review
Determinants of Money Demand
1. The interest rate: r (negative effect)
2. The dollar volume of transactions (positive effect)
a. Aggregate output (income): Y (positive effect)
b. The price level: P (positive effect)
• Money demand is a stock variable,
measured at a given point in time.
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Karl Case, Ray Fair
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Determinants of
Money Demand: Review
• Money demand answers the
question:
• How much money do firms and
households desire to hold at a specific
point in time, given the current interest
rate, volume of economic activity, and
price level?
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Karl Case, Ray Fair
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Equilibrium Interest Rate
© 2004 Prentice Hall Business Publishing
• The point at which
the quantity of
money demanded
equals the quantity
of money supplied
determines the
equilibrium interest
rate in the economy.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Equilibrium Interest Rate
© 2004 Prentice Hall Business Publishing
• At r1, the amount of
money in circulation is
higher than
households and firms
wish to hold. They
will attempt to reduce
their money holdings
by buying bonds.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Equilibrium Interest Rate
© 2004 Prentice Hall Business Publishing
• At r2, households
don’t have enough
money to facilitate
ordinary transactions.
They will shift assets
out of bonds and into
their checking
accounts.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Changing the Money
Supply to Affect the Interest Rate
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• An increase in the
supply of money
lowers the rate of
interest.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Increases in Y and Shifts
in the Money Demand Curve
© 2004 Prentice Hall Business Publishing
• An increase in
aggregate output
(income) shifts the
money demand curve,
which raises the
equilibrium interest rate.
• An increase in the price
level has the same
effect.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Looking Ahead: The Federal
Reserve and Monetary Policy
• Tight monetary policy refers to Fed
policies that contract the money
supply in an effort to restrain the
economy.
• Easy monetary policy refers to Fed
policies that expand the money
supply in an effort to stimulate the
economy.
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Karl Case, Ray Fair
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