principles of economics chapter 11

8/13/2019 principles of economics chapter 11

1/21

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

CHA

PT

E

R

11

Prepared by: Fernando Quijanoand Yvonn Quijano

Money Demand, theEquilibrium Interest Rate, and

Monetary Policy


2/21


The Demand for Money

The main concern in the study of thedemand for money is:

How much of your financial assets you

want to hold in the form of money, whichdoes not earn interest, versus how muchyou want to hold in interest-bearingsecurities.


3/21


The Transactions Motive

There is a trade-off between the liquidity ofmoney and the interest income offered byother kinds of assets.

The t ransact ions mot iveis the mainreason that people hold moneyto buythings.


4/21


The Transactions Motive

Simplifying assumptions in the study of thedemand for money:

There are only two kinds of assets available tohouseholds: bonds and money.

The typical households income arrives once a

month, at the beginning of the month.

Spending occurs at a completely uniform ratethe same amount is spent each day.

Spending is exactly equal to income for themonth.


5/21


The Nonsynchronization ofIncome and Spending

The mismatch between thetiming of money inflow andthe timing of money outflowis called thenons ynchron izat ion of

incom e and spend ing.

Income arrives only once a month, butspending takes place continuously.


6/21


Money Management

Jim could decide todeposit his entirepaycheck ($1,200) into hischecking account at the

start of the month and runhis balance down to zeroby the end of the month.

In this case, his average

money holdings would be$600.


7/21 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

Money Management

Jim could decide todeposit half of hispaycheck ($1,200) into hischecking account, and buy

a $600 bond with the otherhalf. At mid-month, hecould sell the bond anddeposit the $600 into his

checking account. Month over month, his

average money holdingswould be $300.



The Optimal Balance

There is a level of average money holdingsthat earns Jim the most profit, taking intoaccount both the interest earned on bonds

and the cost paid for switching from bondsto money. This level is his optimal balance.

An increase in the interest rate lowers the

optimal money balance. People want totake advantage of the high return on bonds,so they choose to hold very little money.



The Speculation Motive

The speculation mo tiveisone reason for holdingbonds instead of money:Because the market value

of interest-bearing bonds isinversely related to theinterest rate, investors maywish to hold bonds when

interest rates are high withthe hope of selling themwhen interest rates fall.



The Speculation Motive

If someone buys a 10-year bond with a fixedrate of 10%, and a newly issued 10-yearbond 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) andexpected to fall (rise), demand for bonds islikely to be high (low) and money demand islikely to be low (high).



The Total Demand for Money

The total quantity of money demanded in theeconomy is the sum of the demand forchecking account balances and cash by both

households and firms. The quantity of money demanded at any

moment depends on the opportunity cost of

holding money, a cost determined by theinterest rate. A higher interest rate raises theopportunity cost of holding money and thusreduces the demand for money.



The Determinants of Money Demand

The total demand for money in theeconomy depends on the total dollarvolume of transactions made.

The total dollar volume of transactions, inturn, depends on the totalnumber oftransactions, and the averagetransaction

amount.



Transactions Volume andthe Level of Output

When output (income)rises, the totalnumberof transactions rises,

and the demand formoney curve shifts tothe right.



Transactions Volume andthe Price Level

When the price levelrises, the averagedollar amount of each

transaction rises; thus,the quantity of moneyneeded to engage intransactions rises, and

the demand for moneycurve shifts to the right.



The Determinants of Money Demand

Money demand is not a flow measure.Rather it is a stock variable, measured at agiven point in time.

Money demand answers the question: How much money do firms and households

desire to hold at a specific point in time, given thecurrent interest rate, volume of economic activity,

and price level? How much of its assets a household holds in

the form of money is different from howmuch of its income it spends during the year.



The Equilibrium Interest Rate

The point at which thequantity of moneydemanded equals the

quantity of moneysupplied determinesthe equilibrium interestrate in the economy.




At r1, amount of moneyin circulation is higherthan households and

firms want to hold.They will attempt toreduce their moneyholdings by buying

bonds.




At r2, households donthave enough money tofacilitate ordinary

transactions. They willshift assets out ofbonds and into theirchecking accounts.


19/21


Changing the Money Supplyto Affect the Interest Rate

An increase in the supplyof money lowers the rateof interest.

To expand the moneysupply the fed can reducethe reserve requirement,cut the discount rate, orbuy U.S. government

securities in the openmarket.


20/21


Increases in Yand Shifts inthe Money Demand Curve

An increase in aggregateoutput (income) shifts themoney demand curve,which raises the

equilibrium interest ratefrom 7 percent to 14percent.

An increase in the price

level has the same effect.


21/21

2002 Prentice Hall Business Publishing Principles of Economics 6/e Karl Case Ray Fair

The Federal Reserve andMonetary Policy

Tight monetary pol icyrefers to Fedpolicies that contract the moneysupply in an effort to restrain the

economy. Easy monetary pol icyrefers to Fed

policies that expand the moneysupply in an effort to stimulate theeconomy.

principles of economics chapter 11

Documents