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
• The previous chapter covered the money supply and
how money is created. This chapter covers the demand
for money.
• 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 rate 
© 2004 Prentice Hall Business Publishing
interest received per year
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:
• A household or business wants only to hold a fraction of
its financial wealth as money. or
• 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.
• 1.
Money earns no interest (or very little interest).
• 2.
Other financial assets do earn interest.
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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 Transaction Motive
• There is a trade-off (‫ )مفاضلة‬between the
liquidity of money and the interest income
offered by other kinds of assets.
According to Keynes there were three motives for
holding money:
1. transactions,
2. precautionary, (‫)االحتياط والطوارئ‬
3. speculative.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Transaction Motive
• Of these the transactions motive is most
important today
• The transaction motive is the main reason that
people hold money—to buy things.
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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 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.
For the first half of the month Jim has more than his
average of $600 on deposit, and for the second half of the
month he has less than his average.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Money Management
• Is anything wrong with
Jim's strategy?
• Yes, Jim’s 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
• The optimal balance (‫ )التوازن األمثل‬is 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. When interest rates are high people
tend 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
Appendix : The Demand for
Money: A Numerical Example
1
2
NUMBER OF AVERAGE MONEY
Switches
HOLDINGSb
0
1
2
3
4
$600.00
300.00
200.00
150.00*
120.00
3
4
AVERAGE BOND INTEREST
Holdings
Earned
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. that is, the number of times you sell a bond. calculated as 600/(col.1+ 1). calculated 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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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
The Speculation Motive
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• The speculation motive:
Because the market
value of interestbearing 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
• Suppose the interest-bearing bond was 10%
and it has increased to 12% what will occur?
• When interest rates on bonds increased, the
Investors will try to sell the old bonds and buy
new bonds with higher interest rates. At the
same time no one has a willingness to buy the
old bond with the same price. The market value
of old bond will decline
• So, interest rates and the market value of bonds
have an inverse relationship.
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The value of bonds and interest rates
interest-bearing bonds from 10% to 12%
demand on the old bonds
try to sell the old price
investors will
no one has the
willingness to buy it with the same price
market value of bonds
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Karl Case, Ray Fair
the
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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
The Speculation Motive
• suppose I bought a bond for $1000 that offers
10% interest and hold it for a year, then decide
to sell it. In the meantime, interest rates have
risen and a similar bond now offers 12% a year.
Could I sell my bond for $1000? No, because
why would anyone buy it when he or she could
spend the same amount on a new bond and
earn higher interest, I would have to lower the
price of the bond in order to sell it. Thus, interest
rates and the market value of bonds have an
inverse relationship.
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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 10-year 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.
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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.
• Money demand = the demand for checking account
balances + cash by both households and firms
• Like households, firms must manage their money. They
have payrolls to meet and purchases to make; they
receive cash and checks from sales; and many firms
that deal with the public must make change—they need
cash in the cash register. Thus, just like Jim, firms need
money to engage in ordinary transactions.
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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
Money demand and interest rates
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• When interest rates
increased the quantity
of money demand
declines
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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)
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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
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• 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
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• 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
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• 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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C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and
Monetary Policy
Review Terms and Concepts
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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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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
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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