1 of 23 Lecture 7 Interest Rates and Bond PricesThe Demand for MoneyThe Transaction MotiveThe Speculation MotiveThe Total Demand for MoneyThe Effects of Income and the Price Level on the Demand for MoneyThe Equilibrium Interest RateSupply and Demand in the Money MarketChanging the Money Supply to Affect the Interest RateIncreases in Y and Shifts in the Money Demand Curve Money Demand and the Equilibrium Interest Rate

2 of 23 Interest Rates and Bond Prices Interest The fee that borrowers pay to lenders for the use of their funds.

3 of 23 The Demand for Money transaction motive The main reason that people hold money—to buy things. The Transaction Motive 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 of money, which does not earn interest, versus how much you want to hold in interest-bearing securities, such as bonds.

4 of 23 The Demand for Money The Transaction Motive Income arrives only once a month, but spending takes place continuously.  FIGURE 11.1 The Nonsynchronization of Income and Spending

5 of 23 The Demand for Money 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. The Transaction Motive

6 of 23 The Demand for Money The Transaction Motive 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 balance would be $600.  FIGURE 11.2 Jim’s Monthly Checking Account Balances: Strategy 1

7 of 23 The Demand for Money The Transaction Motive Jim could also choose to put half of his paycheck into his checking account and buy a bond with the other half of his income. At midmonth, Jim would sell the bond and deposit the $600 into his checking account to pay the second half of the month’s bills. Following this strategy, Jim’s average money holdings would be $300.  FIGURE 11.3 Jim’s Monthly Checking Account Balances: Strategy 2

8 of 23 The Demand for Money The Transaction Motive The quantity of money demanded (the amount of money households and firms want to hold) is a function of the interest rate. Because the interest rate is the opportunity cost of holding money balances, increases in the interest 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 11.4 The Demand Curve for Money Balances

9 of 23 The Demand for Money The Speculation Motive speculation motive One reason for holding bonds instead of money: Because the market price of interest-bearing bonds is inversely related to the interest rate, investors may want to hold bonds when interest rates are high with the hope of selling them when interest rates fall.

10 of 23 The Demand for Money 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. At any given moment, there is a demand for money—for cash and checking account balances. Although households and firms need to hold balances for everyday transactions, their demand has a limit. For both households and firms, the quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate.

11 of 23 The Demand for Money 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, and households are earning more income and buying more. There are more transactions, for which money is needed. As a result, both firms and households are likely to increase their holdings of money balances at a given interest rate.  FIGURE 11.5 An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right

12 of 23 The Demand for Money The Effects of Income and the Price Level on the Demand for Money TABLE 11.1 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 dollar amount of each transaction. In turn, the average amount of each transaction depends on prices, or instead, on the price level.

13 of 23 The Equilibrium Interest Rate We are now in a position to consider one of the key questions in macroeconomics: How is the interest rate determined in the economy? The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.

14 of 23 The Equilibrium Interest Rate Supply and Demand in the Money Market Equilibrium exists in the money market when the supply of money is equal to the demand for money and thus when the supply of bonds is equal to the demand for bonds. At r 0 the price of bonds would be bid up (and thus the interest rate down), and at r 1 the price of bonds would be bid down (and thus the interest rate up).  FIGURE 11.6 Adjustments in the Money Market

15 of 23 The Equilibrium Interest Rate Changing the Money Supply to Affect the Interest Rate  FIGURE 11.7 The Effect of an Increase in the Supply of Money on the Interest Rate An increase in the supply of money from to lowers the rate of interest from 7 percent to 4 percent.

16 of 23 The Equilibrium Interest Rate Increases in Y and Shifts in the Money Demand Curve  FIGURE 11.8 The Effect of an Increase in Income on the Interest Rate An increase in aggregate output (income) shifts the money demand curve from to, which raises the equilibrium interest rate from 4 percent to 7 percent.

17 of 23 Looking Ahead: The Federal Reserve and Monetary Policy tight monetary policy Fed policies that contract the money supply and thus raise interest rates in an effort to restrain the economy. easy monetary policy Fed policies that expand the money supply and thus lower interest rates in an effort to stimulate the economy.

18 of 23 easy monetary policy interest nonsynchronization of income and spending speculation motive tight monetary policy transaction motive REVIEW TERMS AND CONCEPTS