session 11_money demand_equil interest rate

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Interest Rates and Bond Prices

The Demand for Money

The Transaction MotiveThe Speculation MotiveThe Total Demand for MoneyThe Effects of Income and the Price

Level on the Demand for Money

The Equilibrium Interest RateSupply and Demand in the Money MarketChanging the Money Supply to Affect the

Interest RateIncreases in Yand Shifts in the Money

Demand Curve

Looking Ahead: The Federal Reserveand Monetary Policy

Appendix A: The Various Interest Ratesin the U.S. Economy

Appendix B: The Demand for Money:A Numerical Example

CHAPTER OUTLINE

Money Demand and

the EquilibriumInterest Rate

PART V THE CORE OF MACROECONOMIC THEORY

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For simplicity, let us assume that there are only 2 kinds of assetsavailable to households:

(1) Money: Currency in circulation and deposits in checkingaccounts that do not pay interest.

Versus

(2) Bonds: Assume to cover interest-bearing securities of all

kinds.

When we speak of the demand for money, we are concerned with

how much of your financial assets you want to hold in the form ofmoney, versus how much you want to hold in bonds.

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When we speak of the demand for money, we areconcerned with how much of your financial assets

you want to hold in the form of money, which doesnot earn interest, versus how much you want tohold in interest-bearing securities, such as bonds.

Interest The fee that borrowers pay tolenders for the use of their funds.

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Your decision to hold money involves a trade-offbetween:

a)High liquidity of money to meet your transactionneeds (transaction motive); &

b)Interest income offered by bonds.

The opportunity costof holding money is theinterest rate foregone on bonds. For instance, if you

can earn 8% a year on bond, then holding anadditional P100 in money costs you P8 a year.

(1) The Transaction Motive -the main reason thatpeople hold moneyto buy things.

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The Transaction Motive

Income arrives only once a month, but spending takes place continuously.

FIGURE 26.1 The Nonsynchronization of Income and Spending

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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.

Illustration:

Suppose that Jim earns P1200 per month. How could hemanage his income optimally?



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Jim could decide to deposit his entire paycheck (P1,200) 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 balance would be P600.

FIGURE 26.2 Jims Monthly Checking Account Balances: Strategy 1

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Jim could decide to deposit his entire paycheck (P1,200) 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

balance would be P600 [(starting balance + ending balance) / 2].

But he is giving up interest income from investing in bonds!

CHAPTER

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MoneyDemandandtheEquilibriumI

nterestRate

2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 9of 37

Jim receives P1,200 per month (30 days)

and spends P40 each day. What is his

average money balance?

a. P40.

b. P30.

c. P600.

d. P1,200.

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Jim could also choose to put half of his paycheck into his checking account and buy a bond with the other half ofhis income. At midmonth, Jim would sell the bond and deposit the P600 into his checking account to pay the

second half of the months bills. Following this strategy, Jims average money holdings would be P300.

FIGURE 26.3 Jims Monthly Checking Account Balances: Strategy 2

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Jim could also choose to put half of his paycheck into his checking account and buy a bond with theother half of his income. At midmonth, Jim would sell the bond and deposit the P600 into his checkingaccount to pay the second half of the months bills. Following this strategy, Jims average moneyholdings would be P300.

Jim can continue to lower his average money holdings, but the switching from bonds to money incurscosts such as brokerage fees.

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The Speculation Motive

speculation motive One reason forholding bonds instead of money:Because the market price of interest-bearing bonds is inversely related to theinterest rate, investors may want to holdbonds when interest rates are high withthe hope of selling them when interestrates fall.


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(2) The Speculation Motive

To explain the speculative motive, we need to understand the relation betweenbond prices and interest rates

Illustration:

On Jan 2, 2008, Company XYZ issued a 15-year bond that had a face value ofP1000, with a coupon payment of P100 per year.

Suppose that the market-determined price was P900.

Interest rate = (100/900)*100 = 11.1% p.a.

Suppose that the holder of the XYZ bond (Jim) wanted to sell after a year, what

price could he get?

It all depends on the prevailing interest rate. Let say the interest rate on Jan 2,

2009 was 20%, do you think he will be able to sell for more or less than P900?

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On Jan 2, 2009, another company ABC issued a 15-year bond that had a facevalue of P1000. The market-determined price was P900. At the prevailing

interest rate of 20%, the coupon payment was P180 p.a.

As a rational investor, would you buy from:

(a) Jim at P900, with a coupon payment of P100 per year

(b) company ABC at P900, with a coupon payment of P180 per year

Of course, a rational person would buy from company ABC!

So, in order to dispose of his bond holding, Jim has to lower his selling price

(say to P500).

When interest rate from 11.1% to 20%, the prices of existing bonds fall

(from P900 to P500).

This implies a inverse relation between bond prices and interest rates.

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(2) The Speculation Motive

When interest rates are high

When interest rates are higher than normal, investors expect them to fall in thefuture (and prices of existing bonds will rise).

There is a speculative motive for holding more bonds now (and hence less

money), with the hope of selling them in future when bond prices rise (i.e.

when interest rates fall).

When interest rates are low

When interest rates are lower than normal, investors expect them to rise in the

future (and prices of existing bonds will fall).

There is a speculative motive for holding more money now (and hence lessbonds), with the hope of buying bonds in future when the prices fall (i.e. wheninterest rates rise).

The demand for money depends negatively on interest rate (i.e. the moneydemand curve is downward-sloping).

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The quantity of money demanded (the amount of money households and firms want to hold) is a function ofthe interest rate. Because the interest rate i s the opportunity cost of holding money balances, increases in theinterest rate reduce the quantity of money that firms and households want to hold and decreases in the

interest rate increase the quantity of money that firms and households want to hold.

FIGURE 26.4 The Demand Curve for Money Balances

CHAPTER

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MoneyDemandandtheEquilibrium

InterestRate


Assume that there are no management

costs associated with buying and

selling bonds. What is the impact of an

increase in the interest rate on money

holdings and interest revenue?

a. Both money holdings and interest

revenue would rise.

b. Both money holdings and interest

revenue would decline.

c. Money holdings would rise and interest

revenue would decline.

d. Money holdings would decline, andinterest revenue would rise.

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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 cashby both householdsand firms.

At any given moment, there is a demand formoneyfor cash and checking account balances.

Although households and firms need to hold

balances for everyday transactions, their demandhas a limit. For both households and firms, thequantity of money demanded at any moment

depends on the opportunity cost of holding money,

a cost determined by the interest rate.


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InterestRate


Which of the following is a better measure

of the opportunity cost of holdingmoney balances?

a. The demand for money curve.

b. The interest rate.

c. The transactions motive.

d. The optimal money balance.

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The Total Demand for Money

ATMs and the Demand

for MoneyItaly makes a great case study of theeffects of the spread of ATMs on the

demand for money. In Italy, virtuallyall checking accounts pay interest.What doesnt pay interest is cash.In other words, in Italy there is an

interest cost to carrying cash instead

of depositing the cash in a checkingaccount.

Orazio Attansio, Luigi Guiso, and Tullio Jappelli, The Demand for Money, FinancialInnovation and the Welfare Costs of Inflation: An Analysis with Household Data, Journal

of Political Economy, April 2002.

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The Effects of Income and the Price Level on the Demand for Money

An increase in Y means that there is more economic activity. Firms are producing and selling more, andhouseholds are earning more income and buying more. There are more transactions, for which money isneeded. As a result, both firms and households are likely to increase their holdings of money balances at a

given interest rate.

FIGURE 26.5 An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve

to the Right

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The Effects of Income and the Price Level on the Demand for Money

TABLE 26.1 Determinants of Money Demand

1. The interest rate: r (The quantity of money demanded is a negative function of the

interest rate.)

2. The dollar volume of transactions

a. Aggregate output (income): Y(An increase in Y shifts the money demand curve to

the right.)

b. The price level: P(An increase in P shifts the money demand curve to the right.)

The amount of money needed by firms and

households to facilitate their day-to-day

transactions also depends on the average dollaramountof each transaction. In turn, the average

amount of each transaction depends on prices, orinstead, on the price level.

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Other Determinants of Money Demand

The demand of money depends on the total dollar volume of transactions in the

economy.

Two components of total dollar volume of transactions are:a) How many transactions?

b) How much is the average transaction amount?

How many transactions?

A reasonable indicator for the number of transactions is aggregate output(income), Y.

When Y , there are more transactions in the economy, and Md shifts to theright.

CHAPTER

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InterestRate


The demand for money increases when:

a. Both the dollar volume of transactions and theaverage transaction amount increase.

b. Both the dollar volume of transactions and theaverage transaction amount decrease.

c. The dollar volume of transactions increasesand the average transaction amountdecreases.

d. The dollar volume of transactions decreasesand the average transaction amountincreases.


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The Equilibrium Interest Rate

We are now in a position to consider one of thekey questions in macroeconomics: How is the

interest rate determined in the economy?

The point at which the quantity of moneydemanded equals the quantity of money

supplied determines the equilibrium interest

rate in the economy.

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Supply and Demand in the Money Market

Equilibrium exists in the moneymarket when the supply of money

is equal to the demand for moneyand thus when the supply of bonds

is equal to the demand for bonds.

At r0 the price of bonds would be

bid up (and thus the interest ratedown), and at r1 the price of bonds

would be bid down (and thus theinterest rate up).

FIGURE 26.6 Adjustmentsin the Money Market

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nterestRate


When the interest rate is above the equilibriuminterest rate:

a. People will move out of bonds and intomoneyhold larger cash balances.

b. The quantity of money demanded is too highto achieve equilibrium.

c. The quantity of money demanded is greaterthan the quantity of money supplied.

d. There is more money in circulation thanhouseholds and firms want to hold.

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Changing the Money Supply to Affect the Interest Rate

FIGURE 26.7 The Effect of

an Increase in the Supply ofMoney on the Interest Rate

An increase in the supply of moneyfrom to lowers the rate of

interest from 14 percent to 7percent.

CHAPTER

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InterestRate


An increase in the money supply, without a

change in the demand for money will:

a. Increase the equilibrium interest rate.

b. Decrease the equilibrium interest rate.

c. Result in an excess demand for money.d. Decrease the quantity of money

demanded.

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Increases in Yand Shifts in the Money Demand Curve

FIGURE 26.8 The Effect of

an Increase in Income on theInterest Rate

An increase in aggregate output

(income) shifts the money demandcurve from to , which raises

the equilibrium interest rate from 7percent to 14 percent.


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How much is the average transaction amount?

The average dollar amount of each transaction depends on the prices, P.

If P twice, the dollar amount of each transaction also double (twice as muchmoney is needed to conduct the same real transaction), and Md shifts to theright.

Md = P x L(Y, r)

Money demand is proportional to the price level. If P doubles, Md will alsodouble

For any given P, money demand depends (through the function L) on Y and r.

When Y , Md When r , Md

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Looking Ahead: The Federal Reserve and Monetary Policy

tight monetary policy Fed policies that contractthe money supply and thus raise interest rates in

an effort to restrain the economy.

easy monetary policy Fed policies that expandthe money supply and thus lower interest rates in

an effort to stimulate the economy.

CHAPTER

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nterestRate


If the Fed wants to maintain the interest rateconstant, it will have to:

a. Increase the money supply when the demandfor money increases.

b. Increase the money supply when the demandfor money decreases.

c. Leave the money supply unchangedregardless of changes in the demand formoney.

d. Decrease the reserve requirement when thedemand for money shifts to the left.

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nterestRate


easy monetary policy

interest

nonsynchronization of income

and spending

speculation motive

tight monetary policy

transaction motive

REVIEW TERMS AND CONCEPTS

CHAPTER

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InterestRate


THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY

A P P E N D I X A

THE TERM STRUCTURE OF INTEREST RATES

The term structure of interest ratesis the

relationship among the interest rates offered on

securities of different maturities.

According to a theory called the expectationstheory 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.

Peoples expectations of higher future short-term

interest rates are likely to increase. These

expectations will then be reflected in current long-term interest rates.

CHAPTER

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InterestRate


THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY

A P P E N D I X A

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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TABLE 11B.1 Optimu m Money Holdings

1Number ofSwitchesa

2Average Money

Holdingsb

3Average Bond

Holdingsc

4InterestEarnedd

5Cost of

Switchinge

6Net

Profitf

r= 5 percent

0 P600.00 P 0.00 P 0.00 P0.00 P 0.00

1 300.00 300.00 15.00 2.00 13.00

2 200.00 400.00 20.00 4.00 16.00

3 150.00* 450.00 22.50 6.00 16.504 120.00 480.00 24.00 8.00 16.00

Assumptions: Interest rate r = 0.05. Cost of switching from bonds to money equals P2 per transaction.

r= 3 percent

0 P600.00 P 0.00 P 0.00 P0.00 P 0.00

1 300.00 300.00 9.00 2.00 7.00

2 200.00* 400.00 12.00 4.00 8.00

3 150.00 450.00 13.50 6.00 7.50

4 120.00 480.00 14.40 8.00 6.40

Assumptions: Interest rate r = 0.03. Cost of switching from bonds to money equals P2 per transaction.

*Optimum money holdings. a That is, the number of times you sell a bond. b Calculated as 600/(col. 1 + 1). c

Calculated as 600 col. 2.d Calculated as r col. 3, where r is the interest rate. e Calculated as t col. 1, where t is the cost per switch (P2). f

Calculated as col. 4 col. 5

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Number of switches:

0 = Jim puts all the P1200 into his checking account.

1 = Jim buys one bond, indicating he puts P600 into his check ing account,and uses the remaining P600 to buy bond.

2 = Jim buys two bonds, indicating that he puts P400 into his checking

account, and buys two P400 bonds.

3 = Jim buys three bonds, indicating that he puts P300 into his checkingaccount, and buys 3 P300 bonds.

4 = Jim buys four bonds, indicating that he puts P240 into his checking

account, and buys 4 P240 bonds.

Average Money Holdings (AMH):

AMH = (starting balance + ending balance) / 2

When switches = 0, AMH = (1200 + 0) / 2 = P600

When switches = 1, AMH = (600 + 0) / 2 = P300

When switches = 2, AMH = (400 + 0) / 2 = P200When switches = 3, AMH = (300 + 0) / 2 = P150When switches = 4, AMH = (240 + 0) / 2 = P120

Average Bond Holdings (ABH):

ABH = (starting balance + ending balance) / 2

When switches = 0, ABH = (0 + 0) / 2 = P0

When switches = 1, ABH = (600 + 0) / 2 = P300When switches = 2, ABH = (800 + 0) / 2 = P400



Summary:

When r= 5%, optimal money holdings = P150When r= 3%, optimal money holdings = P200

The lower the rate, the more money on average is held.

The higher the rate, the higher the opportunity cost (more interest foregone)

from holding money, the less money on average is held.

The demand for money depends negatively on interest rate (i.e. themoney demand curve is downward-sloping).

session 11_money demand_equil interest rate

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