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