TM 14-1 Copyright © 1998 Addison Wesley Longman, Inc. Motives for Holding Money Transaction

TM 14-2 Copyright © 1998 Addison Wesley Longman, Inc. Motives for Holding Money Transaction Precautionary

TM 14-3 Copyright © 1998 Addison Wesley Longman, Inc. Motives for Holding Money Transaction Precautionary Portfolio

TM 14-4 Copyright © 1998 Addison Wesley Longman, Inc. Portfolio Motive The precautionary and transaction motives justify the classical economists’ argument that income determines the demand for money. The Portfolio motive distinguishes the classical and Keynesian theory of demand for money.

TM 14-5 Copyright © 1998 Addison Wesley Longman, Inc. Portfolio Motive According to the Keynes, there is a speculative motive for holding money.

TM 14-6 Copyright © 1998 Addison Wesley Longman, Inc. Portfolio Motive According to the Keynes, there is a speculative motive for holding money. People hold money to take advantage of variation in bond prices in response to the expected changes in interest rates.

TM 14-7 Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates Perpetuity: Non-maturing bond that pays an infinite stream of coupon returns.

TM 14-8 Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates What is the current market price of a bond that matures two years from now?

TM 14-9 Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates What is the current market price of a bond that matures two years from now? PV = C/ (1+r) + C/ (1+r) 2 + FV/ (1+r) 2

TM Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates What is the current market price of a bond that matures n years from now? PV = C/ (1+r) +… + C/ (1+r) n + FV/ (1+r) n

TM Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates What is the current market price of a perpetuity ? 1) P B = C/ (1+r) + C/ (1+r) 2 + C/ (1+r) 3 + C/ (1+r) 4 + C/ (1+r) 5….

TM Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates What is the current market price of a perpetuity ? We can reduce equation # 1 to a simple formula that shows the inverse relationship between bond prices and interest rates.

TM Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates What is the current market price of a perpetuity ? We can reduce this to a simple formula that shows the inverse relationship between bond prices and interest rates. In order to do so we should multiply both sides by (1+r).

TM Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates What is the current market price of a perpetuity ? We can reduce this to a simple formula that shows the inverse relationship between bond prices and interest rates. In order to do so we should multiply both sides by (1+r). 2) (1+r) P B = C + C/ (1+r) 1 + C/ (1+r) 2 + C/ (1+r) 3 + C/ (1+r) 4 ….]

TM Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates What is the current market price of a perpetuity ? We can reduce this to a simple formula that shows the inverse relationship between bond prices and interest rates. In order to do so we should multiply both sides by (1+r). If we subtract 1 from 2, we have: (1+r) P B - P B = C + C/ (1+r) 1 + C/ (1+r) 2 + C/ (1+r) 3 + C/ (1+r) 4 ….] - [C/ (1+r) 1 + C/ (1+r) 2 + C/ (1+r) 3 + C/ (1+r) 4 ……..]

TM Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates What is the current market price of a perpetuity ? We can reduce this to a simple formula that shows the inverse relationship between bond prices and interest rates. In order to do so we should multiply both sides by (1+r). If we subtract 1 from 2, we have: (1+r) P B - P B = C + C/ (1+r) 1 + C/ (1+r) 2 + C/ (1+r) 3 + C/ (1+r) 4 ….] - [C/ (1+r) 1 + C/ (1+r) 2 + C/ (1+r) 3 + C/ (1+r) 4 ……..] eliminating those with +s and -s, we have :

TM Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates What is the current market price of a perpetuity ? We can reduce this to a simple formula that shows the inverse relationship between bond prices and interest rates. In order to do so we should multiply both sides by (1+r). If we subtract 1 from 2, we have: (1+r) P B - P B = C + C/ (1+r) 1 + C/ (1+r) 2 + C/ (1+r) 3 + C/ (1+r) 4 ….] - [C/ (1+r) 1 + C/ (1+r) 2 + C/ (1+r) 3 + C/ (1+r) 4 ……..] eliminating those with +s and -s, we have (1+r) P B - P B = C or (1+r -1 ) P B = C P B = C / r

TM Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates P B = C / r This says that bond price, P B,varies inversely with interest rate, r. The higher the interest rates the lower bond prices. Or, the higher the bond prices the lower the interest rates.

TM Copyright © 1998 Addison Wesley Longman, Inc. Bond Prices and Interest Rates Question: If you expect interest rates to rise (fall) tomorrow, what will you advise your client?

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? The Influences on Money Holding The quantity of money people hold depends on: 1) The price level 2) The interest rate 3) Real GDP 4) Financial innovation

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? The Price Level Nominal money is the quantity of money measured in dollars.

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? The Price Level Nominal money is the quantity of money measured in dollars. The quantity of nominal money demanded is proportional to the price level.

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? The Price Level Nominal money is the quantity of money measured in dollars. The quantity of nominal money demanded is proportional to the price level. Real money is the quantity of money measured in constant dollars.

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? The Price Level Nominal money is the quantity of money measured in dollars. The quantity of nominal money demanded is proportional to the price level. Real money is the quantity of money measured in constant dollars. The quantity of real money demanded is independent of the price level.

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? The Interest Rate. The opportunity cost of holding money is the interest rate a person could earn on assets they could hold instead of money.

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? Real GDP Money holdings depend upon planned spending.

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? Real GDP Money holdings depend upon planned spending. The quantity of money demanded in the economy as a whole depends on Real GDP.

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? Financial Innovation Changing technologies affect the quantity of money held.

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? Financial Innovation Changing technologies affect the quantity of money held. These include: Daily interest checking deposits

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? Financial Innovation Changing technologies affect the quantity of money held. These include: Daily interest checking deposits Automatic transfers between checking and savings deposits

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? Financial Innovation Changing technologies affect the quantity of money held. These include: Daily interest checking deposits Automatic transfers between checking and savings deposits Automatic teller machines

TM Copyright © 1998 Addison Wesley Longman, Inc. what determines the demand for money? Financial Innovation Changing technologies affect the quantity of money held. These include: Daily interest checking deposits Automatic transfers between checking and savings deposits Automatic teller machines Credit cards

TM Copyright © 1998 Addison Wesley Longman, Inc. The Demand for Money The Demand for Money Curve The demand for money is the relationship between the quantity of real money demanded and the interest rate.

TM Copyright © 1998 Addison Wesley Longman, Inc. The Demand for Money Real money (trillions of 1992 dollars) Interest rate (percent per year) MD

TM Copyright © 1998 Addison Wesley Longman, Inc. The Demand for Money Real money (trillions of 1992 dollars) Interest rate (percent per year) MD Effect of an increase in the interest rate Effect of an increase in the interest rate

TM Copyright © 1998 Addison Wesley Longman, Inc. The Demand for Money Shifts in the Demand Curve for Real Money Changes in real GDP or financial innovation changes the demand for money and shifts the demand curve for real money.

TM Copyright © 1998 Addison Wesley Longman, Inc. Changes in the Demand for Money Real money (trillions of 1992 dollars) Interest rate (percent per year) MD 0

TM Copyright © 1998 Addison Wesley Longman, Inc. Changes in the Demand for Money Real money (trillions of 1992 dollars) Interest rate (percent per year) MD 0 MD 1 Effect of decrease in real GDP or financial innovation

TM Copyright © 1998 Addison Wesley Longman, Inc. Changes in the Demand for Money Real money (trillions of 1992 dollars) Interest rate (percent per year) MD 0 MD 2 Effect of increase in real GDP MD 1 Effect of decrease in real GDP or financial innovation

TM Copyright © 1998 Addison Wesley Longman, Inc. The Demand for Money in the United states