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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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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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Transaction Motive
• There is a trade-off between the
liquidity of money and the interest
income offered by other kinds of
assets.
• The transaction motive is the main
reason that people hold money—to
buy things.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Transaction Motive
Simplifying assumptions in the study of the
demand for money:
• There are only two kinds of assets available
to households: bonds and money.
• The typical household’s income arrives
once a month, at the beginning of the
month.
• Spending occurs at a completely uniform
rate—the same amount is spent each day.
• Spending is exactly equal to income for the
month.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The 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 is called the
nonsynchronization of
income and spending.
• Income arrives only once a month, but
spending takes place continuously.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Money Management
• 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 money holdings
would be $600.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Money Management
• Jim could decide to
deposit half of his
paycheck ($1,200) into
his checking account,
and buy a $600 bond
with the other half. At
mid-month, he could
sell the bond and
deposit the $600 into
his checking account.
• Month over month, his average money
holdings would be $300.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Optimal Balance
• There is a level of average money holdings
that earns Jim the most profit, taking into
account both the interest earned on bonds
and the cost paid for switching from bonds
to money. This level is his optimal balance.
• An increase in the interest rate lowers the
optimal money balance. People want to take
advantage of the high return on bonds, so they
choose to hold very little money.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Speculation Motive
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• The speculation motive:
Because the market value
of interest-bearing bonds is
inversely related to the
interest rate, investors may
wish to hold bonds when
interest rates are high with
the hope of selling them
when interest rates fall.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Speculation Motive
• If someone buys a 10-year bond with a
fixed rate of 10%, and a newly issued 10year bond pays 12%, then the old bond
paying 10% will have fallen in value.
• Higher bond prices mean that the interest a
buyer is willing to accept is lower than
before.
• When interest rates are high (low) and
expected to fall (rise), demand for bonds is
likely to be high (low) thus money demand
is likely to be low (high).
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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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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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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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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Transactions Volume
and the Price Level
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• 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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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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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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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
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• 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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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Review Terms and Concepts
© 2004 Prentice Hall Business Publishing
easy monetary policy
interest
interest rate
monetary policy
nonsynchronization of income
and spending
speculation motive
tight monetary policy
transaction motive
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Appendix A: The Various
Interest Rates in the U.S. Economy
• The Term Structure of Interest Rates:
• According to a theory called the
expectations theory of the term structure
of interest rates, the 2-year rate is equal
to the average of the current 1-year rate
and the 1-year rate expected a year
from now.
• People’s expectations of future short-
term interest rates are reflected in
current long-term interest rates.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Appendix A: The Various
Interest Rates in the U.S. Economy
• Types of Interest Rates:
• Three-Month Treasury Bill Rate
• Government Bond Rate
• Federal Funds Rate
• Commercial Paper Rate
• Prime Rate
• AAA Corporate Bond Rate
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Appendix B: The Demand for
Money: A Numerical Example
• The optimal average level of money
holdings is the amount that
maximizes the profits from money
management.
• The cost per switch multiplied by the
number of switches must be
subtracted from interest revenue to
obtain the net profit from money
management.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Appendix B: The Demand for
Money: A Numerical Example
1
2
NUMBER OF AVERAGE MONEY
SWITCHESa
HOLDINGSb
0
1
2
3
4
$600.00
300.00
200.00
150.00*
120.00
3
4
AVERAGE BOND INTEREST
HOLDINGSc
EARNEDd
r = 5 percent
$ 0.00
$ 0.00
300.00
15.00
400.00
20.00
450.00
22.50
480.00
24.00
5
COST OF
SWITCHINGe
6
NET
PROFITf
$0.00
2.00
4.00
6.00
8.00
$ 0.00
13.00
16.00
16.50
16.00
Assumptions: Interest rate r = 0.05. Cost of switching from bonds into money equals $2 per transaction.
0
1
2
3
4
$600.00
300.00
200.00*
150.00
120.00
r = 3 percent
$ 0.00
$ 0.00
300.00
9.00
400.00
12.00
450.00
13.50
480.00
14.40
$0.00
2.00
4.00
6.00
8.00
$ 0.00
7.00
8.00
7.50
6.40
Assumptions: Interest rate r = 0.05. Cost of switching from bonds into money equals $2 per transaction.
*Optimum money holdings. aThat is, the number of times you sell a bond. bCalculated as 600/(col.1+ 1). cCalculated as 600 – col.2.
dCalculated as r x col.3, where r is the interest rate. eCalculated as t x col.1, where t is the cost per switch ($2). fCalculated as col.4 – col.5.
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