11 © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Money Demand, the Equilibrium Interest Rate, and Monetary Policy Prepared by: Fernando Quijano and Yvonn Quijano Appendix A and Appendix B

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 29 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.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 29 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 interest- bearing securities, such as bonds.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 29 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.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 29 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.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 29 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.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 29 Transactions Volume and the Price Level When output (income) rises, the total number of transactions rises, and the demand for money curve shifts to the right.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 29 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.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 29 The Determinants of Money Demand: Review Money demand is a stock variable, measured at a given point in time. 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)

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 29 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?

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 29 The Equilibrium Interest Rate The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 29 The Equilibrium Interest Rate At r 1, 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.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 29 The Equilibrium Interest Rate At r 2, households dont have enough money to facilitate ordinary transactions. They will shift assets out of bonds and into their checking accounts.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 29 Changing the Money Supply to Affect the Interest Rate An increase in the supply of money lowers the rate of interest.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 29 Increases in Y and Shifts in the Money Demand Curve 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.

C H A P T E R 11: Money Demand, the Equilibrium Interest Rate, and Monetary Policy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 29 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.